Hi team,
I had an interview today and got a question that still confuses me a bit
"You're selling a company for 10x multiple, what would be more beneficial/ have bigger impact:
- EBITDA increase for 1 dollar
- Net Working capital decrease for 10 dollars"
So if you are selling for higher EBITDA, you will have $10 higher EV. The decrease in NWC will increase your free cash flow (10+x, x is from EBITDA increase- that will boost our free cash flow), and also increase your cash balance (inventory down, cash up). But cash up will reduce enterprise value as it is a non-core asset. Could someone help me connect the dots here, what am I missing? Or is my logic above wrong?
Further, is there a thread or somewhere where I can test my skills on similar questions.
bump...
I understood the question as the change is in the single year aka change is happening now and it will impact the exit valuation of the company.
So my intuition was telling me it is EBITDA, as already stated our EV is higher by 10.
NWC going down, FCF will be higher and our CFO and cash balance will be higher by 10 (from NWC) and some of that EBITDA increase will increase Net Income so FCF/Cash will be up 10+x.
But more cash mean lower EV, which is this case doesn't matter much as we are valuing company based on multiple.
So my conclusion was, if you increase EBITDA you get 10 more of EV and x in cash. If you get NWC decrease you only get 10 in cash, so I prefer EBITDA.
It is funny because in the real world, at least with manufacturing businesses, the net working capital is usually pegged in the SPA to a set dollar amount reflecting a normalized level. Any net working capital amount over the peg at closing results in a dollar for dollar increase in the purchase price paid. An underage results in a dollar for dollar decrease in the purchase price paid. The seller has to provide a preliminary schedule of unaudited net working capital balances as of a few days before closing. The buyer then has to validate the balances presented and can dispute the number a few months after close if it has a material disagreement with the preliminary net working capital level. Upon resolution of the dispute by the means prescribed in the SPA, any difference between the preliminary and final closing net working capital balance is then repaid to the buyer (assuming the buyer would not dispute the balance if their calculation requires a payment to the seller).
Note that in the foregoing scenario, the seller does not lose money when net working capital decreases pre-closing because they get the benefit of the cash generated. They just have to pass that cash on to the buyer, so there is no net effect.
As far as this question goes in an interview context, if the seller actually gets to keep the cash from the decrease in NWC instead of effectively passing it on to the buyer through a decreased purchase price, that provides $10 of value to the seller.
A $1 increase in EBITDA increases the enterprise value of the business if a constant 10x multiple is applied by $10. For simplicity's sake, let's assume this EBITDA increase occurs because we are adding back a $1 non-recurring expense that the buyer fully agrees should be excluded from EBITDA. The buyer should thus be willing to pay $10 more for the business. The $10 benefit directly increases the equity purchase price because net debt is unchanged.
Thus, you should generally be indifferent between the two scenarios. However, it is important to understand what exactly is being asked. There could be more nuance depending on how it is posed. For example, if we are looking at this from the buyer perspective when analyzing historical data, decreases in net working capital are generally not recurring cash flows whereas EBITDA usually is. Accordingly, if an increase in FCF in the prior year is driven by higher EBITDA, that suggests a higher valuation impact than an increase in FCF driven by a decrease in net working capital. I am almost certain that is not what is being asked, but it just goes to show how stupid these questions are that it can be so unnecessarily confusing.
Thanks.
I agree on +1 EBITDA / +10 EV. But NWC -10 will boost our cash for 10.
If you are equity investor, that will cancel each other, right? So equity stake stays the same.
Okay, so in reality, converting $10 of net working capital to $10 of cash is not a source of value creation. For financial interview bullshit questions, the point is that you are selling the working capital and all other operating assets at a transaction value based on EBITDA. Therefore, if EBITDA is unchanged and net working capital is converted to cash, your enterprise value is unchanged and your net debt decreases. EV - Net Debt = Equity Value, or in other words, the proceeds to the seller. Keep in mind, we are talking about equity value from a FINANCIAL standpoint, not an accounting standpoint. A decrease in NWC obviously changes nothing from a GAAP equity value standpoint unless it is due to a write-off or something.
Enterprise value is essentially equivalent to what the purchaser will pay for a business on a cash-free, debt-free basis. Most bid letters for standard cash deals will ask the purchaser to state their bid (i.e., valuation of the business) on a cash-free, debt-free basis. This means you assume you buy the business with no debt or cash on the balance sheet.
Can confirm based on this answer. I think if you were to dive into the details of WC requirements in an SPA you would absolutely blow away the interviewer.
However, I think they are asking a more finance theoretical question, which is geared more towards what happens to valuation in these specific scenarios.
What's the best way to exercise this type of the questions?
I don't get why you guys are talking about increase in FCF (the prompt is you are a seller not a buyer. As a seller it doesnt matter what happens to the FCF after you sell the business because you are not getting the benefit, unless you rollover which is not the case here.)
$1 increase in EBITDA will transalate to $10 increase in EV and $10 decrease in wc will increase the cash paid to the seller by $10. So net effect is $0. It's a trick question!
If EBITDA goes up by 1, some of it will go to Net Income, so your cash is 10 + x, or?
Generally speaking if you are doing back of the envelop analysis for a service based business EBITDA=FCF and for a capital intensive business EBITDA-CAPEX=FCF. (Assuming service based business, if EBITDA goes up by $1 cash goes up by $1 not $10)
Even if the cash flow effects were intended by the interviewer exactly the same (and others in this thread have already made arguments back and forth), I would (nearly) always prefer higher EBITDA.
When you look at "quality of cash flows" you are seeing whether cash flow is driven by operating cash flow, and whether operating cash flow is driven by EBITDA or non-cash charges or changes in working capital balances, and then whether changes in EBITDA are driven by quality, recurring topline growth or just changes in addbacks. The closer cash flow increases get to real growth in the business, i.e. selling to more customers / at a higher price, the better. Go all the way back to fundamentals.
Going further, the quality of the change in NWC matters a lot as well. WC going down by $1 because Deferred Revenue went up by $1 because you received cash for an order that you can't yet recognize as revenue, is good. WC going down by $1 because you chewed through $1 of inventory without reordering it, could be good, could be bad/weird (going back to the whole normalized NWC debate and whether any pre-deal shenanigans are happening that need to be corrected for in the SPA)
If you are the seller, it doesn't matter. Your exposure to the future cash flows ends when you sell the business. You collect the cash and move on. Likewise, it is posited you are selling at a fixed multiple of EBITDA. Your $1 of EBITDA gets you $10 of purchase price enhancement, nothing more.
No it matters, having higher EBITDA will make your leverage levels look lower and look better to the ratings agencies. Will help buyers, especially financial buyers, get lending for the deal. Will make the deal on a multiple basis look cheaper than otherwise which will drive interest. Will make your EBITDA growth charts for your future investor / LP decks look better. Hope you weren't the one MS'in me for being right.
mark
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