Working capital: The black hole of business sales

When a sale of a business occurs based on an earnings multiple, the operating assets employed in generating those earnings on a day-to-day basis are typically part of the sale price. These consist of goodwill, operating assets and working capital. Surplus assets, underemployed assets or non-business assets accrue to the seller. These are normally surplus cash, investment property, etc. Everyone understands goodwill and operating assets. The working capital is trickier.

The normal phrase in a heads of terms seems innocuous enough and usually reads as “value of business on a debt-free cash-free basis at normalised levels of working capital”. Thus the seller settles all the debt and takes the cash. Cash is the ultimate demonstration of accumulated profit and thus this should accrue to the seller right up to the day of closing.

The interaction between cash, debt and working capital can be complex. Even though the principle is understood by all, it can have a serious impact at completion. To demonstrate, I will need to show some examples.

Johnny Ltd buys in goods to order. They get 60 days’ credit from the supplier and are paid on delivery by their customers. For simplicity I will assume no margin is made. They have one order each month for the same amount, so the end of month accounts will show cash of €200k and liabilities of €200k, being two months of €200k. As this is rolling working capital, there is a constant liability of €200k and the €200k of cash would be considered surplus and due to the seller. Alas, such scenarios never arise but we use it here to demonstrate the principle.

A more likely example is as follows. Assume stock holding of €100k, debtors of €300k and creditors of €175k. Thus the working capital requirement is €225k (100+300-175). This requirement for working capital is funded either by debt or accumulated profits. If it is debt, it will be deducted from the sales price (i.e., debt-free). In any event, this €175k is net assets left behind just like plant and machinery as normalised working capital.

Now let’s evaluate what happens when this company suddenly doubles in size. Let’s also assume a margin of 20% and sales of €1m p.a. I will ignore overheads.

At the end of the first year there is an extra €200k in assets – i.e., extra profit. To support this growth, an extra €300k has been invested in stock and debtors have doubled.

The balance sheet would look as follows at the end of year one.

Thus, the working capital requirement has increased by €425k. This can be partly funded by extra profit of €200k but the remaining balance is funded either by debt or historic cash reserves. The seller is worse off by €225k. They may be compensated by a higher price for the larger business but nevertheless it can in some circumstances result in the seller being worse off even though they have grown the business.

The lessons from this are as follows:

1. Aim to run your working capital as lean as possible as the net amount is assets that are left behind in a sale. This can often take several years to get into shape so should be worked on for some time in advance of a likely sale. It will also facilitate debt-free growth and thus a sustainable, scalable business
2. Run the business so that profit and cash are aligned – after all, what is the point of being in business?

One other thing to be aware of is those items which are not classified as part of normalised working capital. A buyer will look at items which are non-standard and try to classify them as debt. Thus, they will be deducted from sales price.

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