How Does Working Capital Impact The Value Of My Business?

In all transactions, working capital ends up falling into one of three scenarios: 1. Sufficient 2. Surplus 3. Deficient The real question is how much working capital is required for this business to continue operating as it is now and to follow the stated growth trajectory? Working capital levels are assessed to determine where a company sits. Working capital levels are measured against industry norms, typical banking covenant ratios, percentage of forecast sales, and requirements based on financial and operational forecasts. Sufficient working capital levels are usually shown as amounts that have been consistently retained in the business, year after year, while allowing for distributions to shareholders for bonuses or dividends that have not been required to be re-loaned to the business as shareholder loans. What this means is that often a business owner receives an annual shareholder bonus to reduce the taxable income of the company, the company pays the tax on the lower income, the shareholder pays the tax on income received and then the shareholder loans the money back to the business to fund operations, and this often occurs year after year. This is an example of a shareholder financing a companys ongoing operations and shows that the shareholder loan capital is required for the ongoing operations of the business. If the annual distribution is paid out of the company and doesnt come back in as a shareholder loan, this shows that the company is operating form its own resources and can actually distribute the discretionary cash flow. Deficient working capital levels are characterized in two ways. The first is that there is a physical working capital deficit, where there are more current liabilities than current assets and the company will have ongoing difficulty meeting its obligations. The second and less obvious, is where a company still has a positive working capital balance, but the amount of working capital is insufficient to take on new initiatives, support growth and generally requires the business to adopt the status quo. What is considered a surplus working capital position and how can this be justified? Adequate working capital is the working capital to run the business in a sustained state, not considering growth. If the EBITDA that is being used in a multiple approach incorporates forecasted growth in EBITDA, then the amount of working capital should be sufficient to handle the growth profile which would be a higher requirement and may reduce perceived working capital surplus. Every business is different and some of the items that should be considered in the determination of working capital surplus/deficiency are the following:

n Comparison to industry norms for top performing companies n Revenue to working capital ratios n Seasonality n Growth capital expenditure requirements n Inventory turns n A/R days n A/P days n Maximum amount of operating line of credit or cash available n If surplus working capital is being used to gain purchasing discounts

How Does Working Capital Impact The Value Of My Business?

Consider the example below of two otherwise identical companies in the same market, generating the same revenue and EBITDA levels, but the working capital in Zenith Manufacturing is much higher than the other business. All other things considered equal let us look at these examples.

BALANCE SHEET ASSETS Cash & Equivalents Trade Receivables (net) Inventory All Other Current Assets Total Current Assets Fixed Assets (net) Intangible Assets All Other Non-Current Assets Total LIABILITIES Notes Payable - Short Term Current Maturity L/T/D Trade Payables Income Taxes Payable All Other Current Liabilities Total Current Liabilities Long-Term Debt Deferred Taxes All Other Non-Current Debt Total EQUITY Equity Total Liabilities & Equity
ZENITH MANUFACTURING Zenith has a current ratio of 1.78 and a working capital balance of approximately $1.5 Million. Next years sales are forecast at $15 million. $1.2 million EBITDA x 4.0X Multiple = $4.8 million Entity Value Working Capital of $1.5 million of which is $500 thousand is considered a working capital surplus and therefore is added to the purchase price. $4.8 million Entity Value plus $500 thousand excess working capital = $5.3 Million value $5.3 Million Entity Value / $1.2 million EBITDA = 4.41x EBITDA Multiple COMPANY 2 $1.2 million EBITDA x 4X Multiple = $4.8 million Entity Value Working Capital of $600 thousand which is considered insufficient for normal operations by $400 thousand, and is deducted from the purchase price, to result in a $4.5 Million purchase price. $4.4 Million value/ $1.2 million EBITDA = 3.66x EBITDA Multiple By correctly positioning Zenith to the purchaser, the vendor in this situation receives the equivalent of a of an additional EBITDA multiple. As illustrated, if working capital is not positioned properly, a business owner may sell his business at a discount not even realizing he is leaving money on the table. The astute business purchaser would not like to pay for excess working capital and views this as a discount to the purchase price. It is in the best interest of the purchaser to not make the vendor aware of any surplus working capital that may be included in the negotiated purchase price.

$294,021 $1,866,800 $1,166,750 $70,005 3,397,576 672,000 84,000 513,424 $4,667,000 $728,052 $233,350 $700,050 $14,001 $233,350 1,908,803 326,690 9,334 238,017 $2,482,844 2,184,156 $4,667,000

How Does Working Capital Impact The Value Of My Business?

WHAT ARE REDUNDANT ASSETS

Redundant assets are assets that are included on the balance sheet (owned by the company) but are not required for the ongoing operations of the business. Some examples of redundant assets are:

n Marketable securities held by the company in a brokerage account n Corporate retreat or vacation home n The land and building that the company operates from (discussed in a later chapter) n Cash surrender values of life insurance policies n Golf course membership n Large cash balances not used in day to day operations
As in the case of Zenith, the company has cash and equivalents sitting on the balance sheet of approximately $300 thousand. Also included in other non-current assets is the company owned retreat in Palm Springs, California, recently appraised at $500,000. We would consider these items as redundant assets in assessing the value of the business, in concert with an assessment of the working capital (above) whereby we determined that the company has surplus working capital of $1.5 million. Furthermore the company owns its land and buildings. We will also consider these redundant assets because if the company did not own them they could simply lease same or similar facilities to operate from. The reason these items are considered redundant or excess is that because if any of them were removed from the business, the business results would not be unduly impacted and should the business be sold, these assets these assets would not likely be included in a business transaction. Another test for excess assets relates to the discussion above on excess working capital and a comparison to industry norms can determine if a company has excess assets on its balance sheet compared to these industry standards.

How Does Working Capital Impact The Value Of My Business?

ABOUT EQUICAPITA
Equicapita is a private equity fund that acquires established, private, small and medium sized enterprises (SMEs) located primarily in Western Canada. Equicapitas investment drivers are to acquire operating companies at attractive valuations, with a history of generating sustainable cash flow and proven management teams. Equicapita believes that there is: - a generational opportunity to acquire baby boomer SMEs; and - a funding gap in the $2 to $20 million enterprise value range. The retirement of baby boomer business owners has been described as triggering one of the biggest transfers of corporate assets on record in Canada. This creates an environment with an abundance of opportunities to acquire SMEs with long-term operating histories, at attractive cash flow multiples. Equicapita provides investors with access to this alternative asset class via an efficient RRSP eligible structure.

DISCLAIMER
The information, opinions, estimates, projections and other materials contained herein are provided as of the date hereof and are subject to change without notice. Some of the information, opinions, estimates, projections and other materials contained herein have been obtained from numerous sources and Equicapita and its affiliates make every effort to ensure that the contents hereof have been compiled or derived from sources believed to be reliable and to contain information and opinions which are accurate and complete. However, neither Equicapita nor its affiliates have independently verified or make any representation or warranty, express or implied, in respect thereof, take no responsibility for any errors and omissions which maybe contained herein or accept any liability whatsoever for any loss arising from any use of or reliance on the information, opinions, estimates, projections and other materials contained herein whether relied upon by the recipient or user or any other third party (including, without limitation, any customer of the recipient or user). Information may be available to Equicapita and/or its affiliates that is not reflected herein. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice or as a recommendation to enter into any transaction. Additional information is available by contacting Equicapita or its relevant affiliate directly.

How Does Working Capital Impact The Value Of My Business?