Andrew Riley
Director
Key Contact
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Ross McWhir
Deal Advisory Director - M&A
20 February 2024
Effective management of working capital will enhance a company’s cash flow. Businesses that can deliver sustainable improvements in this area can increase their cash headroom, or free up money to invest in future growth opportunities. Ahead of any potential sale of a company, the benefits of good working capital management become even more tangible and will often lead to an increase in the sale proceeds that shareholders receive.
The headline price of a business, commonly known as the “enterprise value”, reflects the buyer’s assessment of its current and expected future profitability. This is often based on a multiple of normalised EBITDA (after adjusting for exceptional items) or a discounted cash flow.
Enterprise value does not take account of a business’s balance sheet, and an enterprise value offer is normally made on a cash/debt free basis, subject to the business having a normal level of working capital at completion. In practice, this means that in order to calculate “equity value”, (the price actually paid to shareholders), there will be pound for pound adjustments for:
Applying the principles above, a typical enterprise to equity value bridge takes the following form:
| Enterprise value | £200m |
| Net cash/(debt) at completion | £10m |
| Add: Net working capital at completion | £20m |
| Less: Target working capital | £15m |
| Working capital surplus/ (shortfall) | £5m |
| Equity value | £215m |
As target working capital is deducted from equity value above, it is advantageous to sellers to make this number as small as possible.
There is no definitive standard as to how target working capital should be calculated, and this will be a point of negotiation between buyers and sellers based on a range of factors specific to each individual deal. However, in our experience, some form of normalised 12-month average is often (but not always) used, as this reference period naturally takes account of seasonality in a business. The 12 months could be historical, forecast, or a hybrid of the two (e.g. 6 back and 6 forward).
To the extent that a business has delivered a reduction in working capital in recent months, this would flow into such a working capital target, provided that the seller can demonstrate that the improvement is a bona fide step change that will continue post-transaction.
Management teams often overlook the potential power of optimising their working capital cycle prior to a deal and tend to place their focus on cost management or EBITDA metrics.
Successful businesses recognise the benefit of strong cash management in strengthening the balance sheet, both as a day-to-day business practice and in order to maximise deal value. As every aspect of operations touches net working capital elements, there are almost always opportunities to sustainably improve.
Whilst there is no one-size-fits-all recipe, management teams need to adopt a structured approach to reviewing the business’s end-to-end operations and to embed a cash culture.
1. Give working capital management focus
Despite being the bedrock of the balance sheet, accounts receivable, accounts payable, and inventory management often take a back seat to revenue growth and cost control. This makes working capital optimisation a challenging task.
Employees at all levels make daily business decisions that impact the cash conversion cycle, so any sustained improvement requires cross-functional cooperation and an organisation-wide focus on cash. This can only be achieved if the “tone from the top” promotes effective working capital management.
2. Understand and baseline the Cash Conversion Cycle
Understanding the process and data that underpins your cash conversion cycle is critical in determining how much liquidity is tied up across procure-to-pay, order-to-cash and forecast-to-fulfil cycles. Management teams following best practices have good data visibility at the individual customer, vendor, and SKU levels. They also assess the efficiency of core processes influencing their end-to-end cash conversion cycle, ensuring the right disciplines, reward structures and cross-function communication channels are in place.
3. Size the prize – where does opportunity sit?
Cross-functional and collaborative efforts are essential to identifying potential working capital improvements. Getting the support of an experienced adviser or assembling an internal team capable of driving change is crucial. Their task is to identify the “long-list” of opportunities – some examples are here :
4. Prioritise Areas of Opportunity
Ranking improvement opportunities by benefit and ease sets the order of priority and creates a roadmap that can be followed. Starting with rapid, "no-regret" actions that can be immediately implemented enhances liquidity and builds momentum. Designing and implementing complex, longer-term initiatives often delivers more benefit, but may not fit in with your sale timeline. Creating the appropriate roadmap that is aligned to your sale timeline will support focussed effort and rigorous attention on deliverability of benefits. At the same time, consider whether actions in this area can align with wider strategic priorities, e.g. Procure-to-pay processes may tie in with a business’s ESG agenda around supply chain.
5. Deliver the improvement through a transformation programme
Running the improvement initiatives in a structured programme separately from ‘Business As Usual’ supports clear accountability. Using the roadmap as a guide, assign sufficient resource and clear ownership of initiatives, set up a governance structure to track progress and launch the first wave of actions. Engaged senior leaders, clear initiative tracking and aligned incentives are instrumental to success.
How far ahead of a deal does this need to be done? It is never too early to reassess/re-examine your company’s cash flow cycle. However, the process of optimising your cash conversion cycle should kick-off at least 12 to 18 months before entering a formal sales process. This timeframe allows:
If you would like to have a conversation with one of our experts on benchmarking your business against your peers, and how you can optimise your working capital performance through adopting best practices to release cash from you balance sheet, please do get in touch with our team below.
Andrew Riley
Ross McWhir