12/29/09

Can we get a discussion going on the importance of working capital? I understand what working capital is, but there just seems to be lots of importance placed on the number in transactions and I don't fully understand why. For example, working capital requirements are often specified in IOIs and LOIs (and I presume purchase agreements), but how and why does this so drastically effect negotiations? I've also heard of a working capital line of credit, but don't really get the use of that...

Anyway... a general discussion/general information of WC and its importance would be much appreciated.

Comments (15)

12/29/09

Working capital is HELLLLLA important. Ordinarily healthy companies, at time go bankrupt because they can't fund their working capital requirements. For one, its one of the primary factors impacting liquidity.

In a nutshell, its important because its a primary source/use of cash in an ongoing enterprise. From a transaction perspective its important because its cash... when buy/selling a company you're assuming the company is being run somewhat efficiently, well you're not just assuming you're kicking the tires on the company as well.

In a transaction perspective, there are typically 'post closing adjustments' which true-up the company's working capital to an agreed upon level. So if the merger was agreed upon at a say, for simplicity purposes, to have 5% of sales as working capital, and when the transaction closes and ownership is transferred its at 4% of sales, a post closing adjustment will be made to deduct 1% of sales from the consideration paid to the sellers.

As for working capital lines... its a VERY important source of capital for select industries. Take an oil refinery. Refineries typically have a few days of inventory. Lets assume theres no pricing lag and AR and AP always offset each other. So oil prices spike from $50 to $150, they now have to increase their inventory by 200%. If they previously had $1bln inventory they now need 3bln inventory. Not cool. So whats an oil refiner to do.... well they are to secure working capital lines of credit which is simply an asset backed loan with the underlying asset being either receivables or inventory. So when oil price spikes, the new need for capital will be provided from the working capital line. Its much like a revolver, except secured by a specific asset and intended to fund working capital needs.

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12/29/09

Are there generally negotiations on WHAT qualifies as working capital, i.e. the proper way to go about the calculation? Also, by post-closing adjustment, do you simply mean the buyers would pay 1% of sales less than they would have if it was at 5%?

So for my understanding... It's similar to cash, which makes sense because it's expected to turn to cash fairly soon. The excess of current assets is considered "cash" because it covers the current liabilities. If it's cash and the level of WC is not at the level agreed upon (essentially a cash shortage), the buyer will pay less.

OK, got that. But what is determined to be a "reasonable" and "fair" level of WC? Is it determined by the industry?

I also do not fully comprehend why the historical WC analysis is totally necessary. It's not difficult to do, but in the sell-side process I was on recently we did a monthly WC analysis going back 24-months... What does that tell a buyer?

12/29/09

#1- it should be pretty standard, dependent on practices for that industry. And yes thats what I mean (re: WC true-up). This is because the target is being purchased at a given price assuming its a turn key operation, and no further investment needs to be made. If I get the keys to the company, and all the computers are gone from the offices, I'm going to tell the sellers "fuck you, i agreed to buy this company with the computers I need to run the business"... (computers are not considered working capital, they are PP&E, but this is just an example for the layperson). So we agree that Ill buy the company with a computer for every administrative employee, when I get the keys if they sold 10 computers without replacing them or firing 10 admins employees, Im going to deduct the cost of 10 computers from the amount I'm paying them, reason being... I agreed to buy this company turnkey, so you're going to pay for the 10 computers I need to buy.

#2- Well its not cash per se. But yeah, you get the gist of it.

#3- level of working capital is specific to the industry and the company, depending on the industry characteristics and the company's business model.

#4- If you're buying a company and need to know how to capitalize the company to weather any routine ups-and-downs, like increased working capital needs, you'll want to understand what impact working capital requirements have historically had on the company's liquidity. You'll need to determine a level of working capital you need and you'll need to determine how much flexibility you need to bake into your capital structure to handle the types of cash needs your company will have going forward. I've seen quarterly historicals going back 10 years to determine optimal capital structure, cash flow volatility, and to plan for cash needs.

12/29/09

Working capital is account receivables plus inventory minus account payables instead of the difference between current assets and current liabilities. It is not cash, but can be 'converted' into cash within one year. It is very important to optimize working capital as it represents a companys' day to day cash flows. This means for example stricter deadlines for receivables and postpone payables.

12/29/09

Thanks, Marcus. So fair to say it's a form of measure of operational efficiency? I would assume a more efficient company could operate on a lower level of working capital, whereas a less efficient company would need more WC to support its day-to-day operations?

In reply to dagobert_duck
12/29/09

dagobert_duck:
Working capital is account receivables plus inventory minus account payables instead of the difference between current assets and current liabilities. It is not cash, but can be 'converted' into cash within one year. It is very important to optimize working capital as it represents a companys' day to day cash flows. This means for example stricter deadlines for receivables and postpone payables.

Is this true? For the WC analysis I've done (and for purposes of calculating FCF in DCFs, LBOs, etc.), it's always non-cash current assets less non-interest bearing current liabilities.

In reply to jimbrowngoU
12/29/09

jimbrowngoU:
Thanks, Marcus. So fair to say it's a form of measure of operational efficiency? I would assume a more efficient company could operate on a lower level of working capital, whereas a less efficient company would need more WC to support its day-to-day operations?

Well its not necessarily a component of how efficient a company is. Take Apple (cell phones only) for example, they have retail stores so they may have higher levels of inventory as compared to say.... other electronics manufacturers like Nokia or RIMM. Its very dependent on the industry for a general framework, and then dictated by the company's business model.

12/29/09

As a closing condition in the acquisition agreement, the seller is typically expected to maintain a normalized level of working capital that should have already been agreed to by the buy and sell side during negotiations.

To the extent that the seller leaves too little working capital (sometimes we use tangible net worth based on GAAP balance sheet items, depends on industry), the buyer would have the right to reduce the purchase price by the working capital deficiency, and to the extent that the seller leaves excess working capital, the buyer would have to increase the purchase price equal to the excess working capital less the normalized working capital. The normalized working capital level is based on historical financials, i.e., median WC/Revenue ratio over last X years. Pull a DEFM or PREFM and search for "purchase price adjustments" typically in the closing conditions.

You had another post on purchase price allocations, and I didn't quite understand your question, but in a PPA you are just allocating the purchase price to the target's identifiable assets, so the existing basis for each balance sheet item (including existing goodwill on target B/S if any) is basically written up or down to the calculated fair values determined in the 141R purchase price allocation.

In reply to Marcus_Halberstram
12/29/09

Marcus_Halberstram:
As for working capital lines... its a VERY important source of capital for select industries. Take an oil refinery. Refineries typically have a few days of inventory. Lets assume theres no pricing lag and AR and AP always offset each other. So oil prices spike from $50 to $150, they now have to increase their inventory by 200%. If they previously had $1bln inventory they now need 3bln inventory. Not cool. So whats an oil refiner to do.... well they are to secure working capital lines of credit which is simply an asset backed loan with the underlying asset being either receivables or inventory. So when oil price spikes, the new need for capital will be provided from the working capital line. Its much like a revolver, except secured by a specific asset and intended to fund working capital needs.

Question: Is the asset backed loan that Marcus is describing can also be known as ''Credit Sleeve''? My 2 cent is that they will provide ST Credit facility to the company and can be backed by any asset commodity or future contracts.

12/29/09

thadonmega, thanks for the walk-thru on WC.

In regards to purchase price allocation... My question is more to the proper way to calculate the allocable portion of the purchase price, i.e. the excess. What is subtracted from the equity purchase price? Shareholder's equity? Or is it tangible book value (SHE - goodwill - intangibles). And when making the balance sheet adjustments, do you write down the target's intangibles to zero and then write-up based on the allocated percentage? Or do you add on the write-up to the existing intangibles balance?

Sorry, I am having trouble explaining this clearly. May have to use examples... Or if someone could just explain using an example (proper adjustments, etc.).

12/29/09

Target B/S before PPA:
Cash: $20
PP&E: $10
Intangibles: $10
Existing Goodwill: $10

Target is acquired for $100 all cash, fully financed bid, and deal has closed.

Target fair values from PPA:
Cash: $20
PPE: $40
Intangibles: $20
Goodwill=PurchasePrice - (FV of all identifiable assets)
=$100 - ($20+$40+$20) = $20

So your write up or write down is just the new FV minus the old basis, e.g., write up for PP&E is $40 - $10 = $30, etc. The other side of the balance sheet would also show the $100 either as debt or stock holder's equity depending on how the deal is financed, e.g., cash financed with debt, cash financed with cash on balance sheet or buyer's stock. The stepped up assets would all come over to the buyer's balance sheet and as far as the target's fair valued balance sheet ties, everything should tie out.

Also check up wiki, for a more detailed example.

12/29/09

A big reason to call out working capital in purchase agreements is because of its liquidity, it can change lot between coming to a substantial agreement and actually closing the deal and wiring the cash. It'd be tough to sell a bunch of factories (or even computers) in a matter of weeks, but monetizing AR or inventory and moving cash around quickly isn't that difficult. To try to avoid that messy scenario, which would probably be illegal anyway even without the clause in the purchase agreement, they make sure they mention it.

12/29/09

Agree with all of the comments above. For MM transactions, deals are typically done on a cash free / debt free basis. This means that the seller gets to keep all of the cash on the balance sheet and assumes all of the debt. Without a target working capital number, the seller could alter standard business practices to accelerate the generation of cash. Then, when the transaction closes, all the cash would accumulate to the seller and the buyer would have to spend additional money returning working capital to normalized levels. Some examples below.

Example 1 - Seller could offer its customers 5% off their outstanding balances if they pay within 15 days (or 5% off if they pay with cash). This would substantially reduce accounts receivable, and therefore working capital, but would not sustained by the new owners.
Example 2 - If the seller was a distributor, they could slow down the replenishment of inventory on hand, increasing their cash position. When they turned over the keys to the new owner, the new owner would have to spend a bunch of cash to bring inventory up to normalized levels.

As you can tell, a working capital target is extremely necessary, and it wouldn't be unheard of to see a lawsuit arise over WC if no target was set. Also, what wasn't mentioned above was what a target looks like or how it is determined. As part of the agreement, the Buyer and Seller negotiate how they want to handle WC. Sometimes it is a set number, and anything above or below it results in a purchase price adjustment. Sometimes it is a band, and as long as the WC delivered is within the band, there is no adjustment (example: $1bn target, with $100mm band, as long as WC delivered is $0.9bn to $1.1bn, no adjustment is made).

In terms of setting the target or the band, this can be done through a number of approaches. Sometimes it is the last 12 months, sometimes last 3 months annualized, 6 months annualized, etc. Sometimes it's a percent of sales, etc. It all depends on the negotiation, and both sides typically fight for a WC target that favors them. For example, if the company is growing rapidly, you'd expect the WC needs to also be growing rapidly. As a result, the average WC over the last 12 months would likely favor the seller as it would set the target much lower than the current needs of the company. In a declining business, the opposite is true, with the last 12 months favoring the buyer.

For those prospective analysts reading this: Don't be afraid if it doesn't make sense. WC targets can be a complicated concept if you aren't familiar with transaction structures.

CompBanker

12/29/09

CB, I think you may be getting sick of hearing this but... thanks. Great explanation. Clarifies everything from above -- thanks to all contributors.

1/18/16

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