🟠 6 Lessons You Need to Know About Working Capital

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This week’s issue is about working capital! This is a topic even well-seasoned experts struggle with. I would consider it an advanced topic.

Many business brokers prefer to avoid a working capital discussion, pushing the risk and diligence onto the buyer. Buyer beware.

Summary of today’s issue:

• ❓ What’s working capital?

• ✍️ A case study (and downloadable excel template)

• 📖 6 lessons to learn

  • Working capital impacts cash flow

  • Working capital is either adjustable or non-adjustable

  • Don’t forget about cash

  • Negative working capital

  • Making money from mismanaged working capital

  • Big balance sheets are risky

• 3 great tweets about working capital

Why does this topic matter so much to me?

I have a friend who acquired a business and almost didn’t survive because 1) he as a buyer did not understand working capital until he experienced a near-death cash crunch and 2) seller withheld information related to working capital that wasn’t addressed in the purchase agreement.

Thankfully he survived and is doing well, but it was an absolutely terrifying 4 months for him. Most of it was preventable. I don’t want you to be in the same situation.

In the small business and micro-PE market (let’s call this <$10M of purchase price), most acquisitions exclude working capital from the purchase, so you as the buyer must bring your own to the table. And figure it out to make sure you aren’t getting the short end of the stick.

There are many tricks & games relating to working capital to both your benefit (if you’re knowledgeable) and to your loss (if you don’t have a clue).

So let’s jump in!

What’s working capital?

I’ve always described working capital as ‘gas in the car’. It’s the operating assets a business needs to consume on a daily basis in order to survive and thrive. Matt Hinson does a great job of taking this analogy a step further in the specific context of a business acquisition.

Some definitions so we’re all clear about the differences between WC and NWC.

Case Study

Below is a simple case study of three companies with the same annual profitability (EBITDA).

Company A has negative working capital. It also uniquely has deferred revenue (they are collecting payments from customers well in advance of delivering the work!). Company A also has minimal inventory requirements with only $50K on hand.

Company B has a relatively low working capital need compared to C, but more than A. Company B needs a little more inventory too.

Company C has has significant working capital needs. It has a huge AR balance, almost $950,000 in the example below (meaning Company C has delivered services, incurred a bunch of costs already, and they still haven’t been paid yet…). Company C also has a significant amount of inventory relative to both Company A and B.

Now, imagine each company grows by 50%, increasing EBITDA from $500K to $750K! Awesome, right? Well, let’s take a look at each company’s unique working capital dynamics to see if this is a good or bad thing!

There are many lessons to glean from this case study, but let’s stick with 6 today.

Lesson 1: Working Capital impacts Cash Flow

If you take nothing else from this, remember this:

Free cash flow = EBITDA ± changes working capital - capital expenditures.

Free cash flow is money in the bank.

EBITDA, while helpful as a profitability and comparison metric, is only part of the cash flow story. Cash is what you use to pay your employees or an upcoming mandatory debt payment.

Company A in the example above generated an additional $250K of EBITDA but had $325K in free cash flow. Nice. 🙌

Company C has a terrible working capital situation…while it generated an extra $250K of EBITDA on paper, it actually required an additional investment (probably a cash equity infusion by you) of $400K in the balance sheet. In this example, Company C has eaten way more cash than it has generated in profit. Ouch. 🚩🚩

Lesson 2: Working Capital is either Adjustable or Non-adjustable.

Knowing the difference between the two can help unlock opportunities after you acquire and understand the ‘real’ working capital needs of a business.

Adjustable WC: A residential HVAC owner has historically allowed his customers to pay him within 30 days of finishing a job. A new owner could to change this billing policy, requiring 50% down on a job at signing and 50% on the day of completion. The result of this change for a $5M revenue company could be hundreds of thousands of dollars of cash in your bank account sooner. and hugely increases your cash flow conversion cycle. What could you do with an extra $300K of cash at $5M revenue company? Probably a lot!

Non-adjustable WC: Your company gets paid by the government and their set terms are 90 days from when services are delivered. This would be a permanent, unchangeable part of the business model assuming. You cannot change the government terms so you should not expect any change or opportunity to do so in the future. This company inherently needs more working capital, and is typically reflected in a company valuation relative to a company that has a faster paying company (all else equal).

Understand the difference? It’s important as a buyer to identify each sub component of working capital and see if it’s something inherent in the business model (Non-adjustable WC) or something flexible based on an operational decision (adjustable WC).

Is AR high because of a personal preference or decision made by the owner? Or is AR high because the top customer could pay faster, but has historically paid in 45 days? Or is AR high because you’re contractually obligated to collecting payment in 90 days?

When assessing a company prior to purchasing, you always assume you will do the same or worse than seller. Expecting that you will somehow change the payment terms of long-term customers for instance, is an operational risk & you should not bake into your base case projections. Always be conservative.

If we could identify that Company C’s working capital was adjustable, this may make the company more attractive because it is likely priced less than Company C. This now becomes an opportunity for a savvy buyer who has the ability to recognize and execute post-close.

Lesson 3: Don’t forget about Cash as part of Working Capital

From an operational perspective, cash is absolutely necessary to operate a business. Ignoring cash levels needed to operate a business is a cardinal sin that I think hits ivory tower folks the hardest as they have never operated a business and may be too focused on NWC. Operators inherently understand the value of cash and ensuring they remain solvent.

Look at the cash balance the seller has kept on hand over the last few years. Trust me: it’s not $0.

Cash on the balance sheet is a necessary part of running a business, so you must understand the ‘why’ behind the cash balance.

To understand the general cash positions historically, look at the business’s daily cash balance in chart format (exclude owner distributions).

Lesson 4: Negative Working Capital

Negative working capital (Company A) is great in a growing company. Conversely, it’s bad if your company revenues are declining. If you expect the company to remain flat or grow, it’s all good. Your business will actually generate MORE cash flow than stated EBITDA. In a sense, you’re getting cash ahead of when you make it.

Shrinking revenue at a negative working capital company has the opposite effect in sucking up more cash, potentially putting you into a liquidity crunch.

Negative working capital companies typically have minimal inventory (no to minimal inventory) and favorable payment terms (low AR or even deferred revenue from collecting money up front from contracts or jobs to be completed).

SaaS companies have these types of favorable working capital positions, charging customers at the beginning of a service period for a monthly or annual contract…this cash up front is one of the reasons SaaS can grow faster organically than other heavy working capital business modes.

Think of ways you can turn your moderate or heavy working capital business into a negative working capital business. Bring customer payment terms forward. Use less inventory. Don’t pay bills in advance, pay them when they’re due.

Lesson 5: Riches in Mismanaged Working Capital

There’s big upside in managing working capital more efficiently as a small business owner.

Company C is arguably a much less valuable company than Company A because buyers assume that it needs that amount of working capital to continue to generate the same amount of profit.

But what if you could buy Company A, make some internal operational or process changes and end up with Company A over 6 months while paying way less for company C at the same time. May be worth the risk.

That’s Alpha and is something to look for when you see a large balance sheet company that you feel seem off or could be run more efficiently.

Lesson 6: Big balances sheets are riskier

High inventory? There’s likely some level of stale or unsellable inventory. You might have too much of one SKU. A manufacturer may discontinue a SKU making it worth $0. There is risk in holding inventory. Do a comprehensive inventory turnover analysis to figure out how much risk is sitting there. Maybe there is an opportunity to reduce inventory levels, but you should NOT bake this into your assumptions.

High AR? Payment terms with current customers are probably unfavorable. AR is just riskier than having the same amount of value in cash. There will always be some amount of customers that don’t pay, so you have to discount it.

Cash is king. Other forms of current assets will always be worth less than cash.

Hope you enjoyed the deep dive case study. Some quality working capital tweets to round out this issue:

1. How an experienced SMB business broker handles working capital in his deals.

Every broker handles net working capital differently. Brokers are the gateway to a seller, so buyers must be flexible and mold their offers to fit the situation. It is critical to understand how much WC the business needs to operate normally (normalized working capital) and it’s on the buyer to figure this out.

2. How working capital in structured in larger M&A transactions

3. Two stories about two very different businesses (with different working capital dynamics!)

Looking to…?

• invest passively in SMBs? Join Accredited investors only…check out the SMB Junction Capital Connector investor network to get in the flow of off-market deals (self funded, independent sponsor, private equity)

• raise equity capital? Submit your deal under LOI for free to the SMB Junction Capital Connector to get intros to value-add accredited investors

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The SMB Scoop 

Ben Tiggelaar

Things I’m currently working on: www.bardocapital.com, www.smbjunction.com, [acquisition made in June 2023 to be announced…]