Why are Accounts Payable excluded from EV?
I somehow understand, that:
– AP are not interest bearing and dont have a financing but an operating role
– it wouldnt make sense for a buyer to pay for acquiring AP
But somehow it feels weird, that from EqV to EV, financial bearing liablities are added but AP is left out. Don't I, as a buyer, eventually also have to pay the supplier, otherwise he will sue me? So don't I eventually have to pay him and thus I implicitly account for this fact by adding AP to EV? As I do with debt?
You know what I mean? Can someone explain? Thanks!
Best regards,
WVRHVMMER
You said it yourself, APs are operating accounts. When doing a DCF, AP comes into play in operating working capital (OWC). If AP goes up a metric fuck ton, and operating working assets don't change at all, then you'd see this reflecting when bridging from EBIAT to uFCF.
Sure but in my view, a DCF is not mandatory for EV. You can very well also get an EV by Multiples or well, just guess your EV and then go to the EV EqV bridge.
Feel like if only using multiples, you're admitting a "market knows best" approach. In which case your A/P would be baked into the EqV.
Here's an example. Let's say a company pays down $10 of A/P. Cash goes down by $10 and A/P goes down by $10. If you use the standard EV formula (EqV+Debt+P/S+NCI-Cash), EV goes up by $10 because of the reduced cash. If you look at the conceptual approach, A/P is an operating liability. Since EV is a reflection of the value of net operating assets (to all investors), if operating liability goes down by $10, then net operating assets is up by $10. And therefore EV is also up by $10. You'd be double counting if you included A/P in the bridge.
Hope this helps
Is it weird that I dont yet fully understand it? I mean normally I am an extremely fast learner. Yesterday I didnt know what an LBO was and after studying it for 3 hours I am very fast at paper LBOs.
But some of the EV EqV stuff is something I cant yet get wrap my head around
Nah man everybody takes a different pace to learn things. Some concepts are harder for others and some easier. Don't worry about how long it takes just get the conceptual understanding.
I recommend this guide to hone your conceptual understanding. https://samples-breakingintowallstreet-com.s3.amazonaws.com/IBIG-04-04-…
I usually don't recommend M&I for the 400 questions guide, but the one above is actually pretty good in giving an in depth understanding.
I think the key point to understand is that A/P is included in EV. It's implicitly accounted for in EqV and it's not a separate investor group, which is why you don't add it back when bridging.
Same reason why you don't include accounts receivables as well as other current assets / current liabilities. Often as part of the purchase there will be a working capital target and if WC varies significantly leading up to the transaction an adjustment may be made. But in general the AR should offset the AP in terms of funding requirements
The responses above are correct from a mechanical perspective in the context of DCF, but OP's question is completely valid. What has been addressed above is how UFCF is impacted by changes in working capital on a year over year basis over a forecast period, but does not answer how a positive/negative net working capital balance (i.e. on a balance sheet as of x date) is captured in the context of a M&A transaction.
To answer your question OP, your initial thought is correct and ultimately comes down to contemplated transaction structure. Generally, the buyer/seller will agree to a "normalized level" of net working capital to run the business, and set that as the "working capital peg". Generally this figure is determined at some point during the due diligence process. Immediately prior to closing, the buyer/seller will re-assess the latest working capital balance, and see if there's a surplus or deficit versus the working capital peg determined earlier (true-up). If a deficit exists (i.e. no change to A/R, inventory, etc. from the working capital peg however A/P has ran up dramatically), generally that differential is taken off the cash consideration paid to the seller (i.e. the buyer will need to pay off this additional A/P at some point in the future).
Amazing, thank you for this great reply! This is very reasonable and now I understand, that there in fact can be an issue with too high A/P. Could you help me draw the conclusion as a last step?
You said, that if A/P increase, this differential ist taken off the cash consideration paid to the seller. Does that mean, that a high true-up of A/P results in a smaller Equity Value, with the EV ultimately staying the same, but the EqV declining (this gap is filled by the A/P true-up)?
Is this correct, or is this still not quite it?
Best regards,
WVRHVMMER
That's right - EV (value of operating assets) is expected to reflect a normalized level of working capital. If there's a working capital deficit, the seller is on the hook for bridging that gap i.e. they either inject cash out of their own pocket, or shave a portion off the equity consideration. The latter is generally what happens, albeit the net impact is identical (seller is out x dollars for funding the deficit).
The other way to think about it from a DCF perspective is if there's truly a working capital deficit, your change in NWC forecasts in your DCF need to factor in a period such that it reverts back to a normalized working capital figure. If you're running a massive deficit today, at some point your A/P needs to go down (i.e. in 2023) which is a use of cash (and will decrease UFCF accordingly). That's the reason we drive working capital forecasts off of ratios i.e. days outstanding rather than in hard $ terms - in your days assumptions, you need reflect what you think a "steady-state" ratio would be, and your change in NWC (in $ terms) will reflect any true-ups relating to if you're over/under the steady-state ratios vs. today. You can't run a NWC deficit into perpetuity.
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