Working capital
Hi monkeys,
I was asked this question and don’t have the answer:
- As a Private Equity investor, would you prefer to invest in a company with a positive or negative working capital and why ?
- Same question if you are on the debt side
Grateful if some monkey can explain.
Thank you !
Ignore my title, I made the account a few years back when I was an undergrad. You would want to clarify what is the steady-state picture of their normalized working capital needs. All things equal, you would want to have normalized negative working capital as it would indicate the company is self-funding and therefore is more likely to be efficient from a cash flow perspective.
Probably negative. Negative working capital means your trade creditors (who you owe) are larger than debtors (who owes you). This is typically seen in businesses which receive cash from customers before they pay creditors / cost of sales. Eg an events business where customers buy tickets in advance (sometimes a long time in advance), and before a large proportion of payments out to suppliers are made. In this scenario the business basically sits on cash for a period of time. It’s beneficial for a few reasons, but primarily because growth can (to some degree) fund itself. An overly simplistic example: the events company can launch lots of new events next year, driving a revenue uplift of (say) 50%. It collects cash in advance of payment of creditors, so it doesn’t need to sink cash into growth in the same way as a positive working cap business. In contrast a manufacturing business (positive working capital) has to invest cash in producing stock - widgets, footballs, whatever - before it can grow revenues and EBITDA by selling more of these products.
My answer would be something along the lines of: “I would invest in negative working capital businesses as growth absorbs less cash - this makes the business more capital efficient / the investment better return-wise”
From an accounting perspective, in a simplified scenario, does this basically mean:
- negative working capital: we sell tickets--> cash increase by 50, accounts payable increase by 50
- positive working capital: we manufacture widgets -> cash decreases by 50, inventory increases by 50 -> inventory decreases by 50, accounts receivable increases by 50
Sorry if stupid question, new to this stuff.
Not a stupid question - yes that’s right. So (given cash isn’t typically part of working capital) the first example is a negative net number and the second is a positive net number. Hope this is all helpful
I would answer it differently and suggest that the trend and potential to change is more important. If you have a heavier NWC business that has been mismanaging and you feel confident that you can reduce (as a % of Revenue), then that drives economic value. If you have a negative NWC business, that is interesting and could help fund growth, but if current assets are growing at a faster clip, it can become a value detractor.
Gotta be careful. Lower receivables on absolute basis might mean slowing top line, for example. Generally you want lower receivables relative to sales, lower inventory relative to COGS, and higher payables relative to COGS. This is so that you have more cash that is free (not locked up) which can be reinvested. One metric to see this is the CCC (cash conversion cycle), which is inventory days plus receivable days less payable days. A negative CCC is seen in some of the most successful companies today.
So you’d want operating net working capital to be negative (this is working capital ex-cash & equiv., liquid securities, debt, short term notes, etc.). But working capital including those items would hopefully be positive so you can cover your short-term liquidity needs.
But this is just an in-place answer and it’s not what you’d think of as an investor. If you want to just buy an asset and assume it stays in that state and you do not sell, you’d always want to buy at a high multiple and at negative op. NWC. But as an investor you always try to buy at a low multiple and therefore at a high op. NWC in hopes that you can improve it (just like your contrarian thesis is to buy low, sell high).
A classic control-equity investor will seek to reduce cash trapped in inefficient working capital cycles in this way. This is powerful in generating FCF as a $1 improvement in WC efficiency goes directly to FCF rather than flowing through taxes.
So what’s an appropriate answer?
”I’d like to buy a business that may currently be fraught with a bloated positive op. NWC. Then I will improve working capital efficiencies towards a lighter op. NWC figure which will accrue to FCF.”
hope this helps.
Some tricky questions to consider:
- when during the working capital cycle do you want to buy for a seasonal business?
- when during the working capital cycle do you want to buy for a cyclical business?
- does your response change to either of these depending on if you’re investing in the debt or equity?
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