• How does working capital affect a business’ valuation?
Article:

How does working capital affect a business’ valuation?

03 June 2021

The effective management of working capital is critical to a business’ survival, in particular in a period with significant fluctuations in activity such as that faced by parts of the hospitality and travel sectors. Further, in a transaction, the level of working capital typically has a £ for £ impact on the equity value, with the price adjusted down if there is a lower than ‘normal’ level of working capital at completion.

In this article we take a look at:

What does the working capital study tell us?
Using working capital management methods as a benchmark against competitors
Pre-deal (buy-side) 
Pre-deal (sell-side)
Post deal

What does the working capital study tell us?

Based on our latest annual working capital study, we can see that businesses had been holding more working capital year on year leading into the pandemic, increasing balance sheets to £288bn in companies with revenues >£50m. The movement was driven largely by an increase in receivables and inventories. Perhaps the availability and cost of cash over recent years has meant that working capital management has not been the focus of C-suites and management teams. However, this position has changed over the last 12 months as companies have focussed on preserving cash to mitigate against uncertainty and fluctuations in trading levels. That said, looking at trends in cash reserves, we can see that the number of businesses claiming to have only 1 to 3 months of cash has increased over the last 6 months with 18% of businesses citing access to cash as their greatest challenge for 2021. With Government support packages phasing out and varying vulnerabilities across the UK, management teams need to prioritise working capital management.

Using working capital management methods as a benchmark against competitors

Cash Conversion Cycle (CCC) is a good indicator of working capital efficiency as it measures the days it takes to turn a business’s investments in inventory and other assets into cash from sales. The shorter the number of days, the more effective the management. What good looks like varies, dependent on the sector and size of your businesses, however tracking this internally and benchmarking against competitors can support continuous improvements.

Below is the end-to-end process that drives working capital. Management teams need to focus on assessing and optimising these to speed up the CCC and release cash from the balance sheet.

Click the image below to see full version.

Pre-deal (buy-side): It is sometimes challenging to get good, granular data needed from the target to calculate the level of working capital that a company needs and hence any potential funding requirement or cash release opportunity post deal. During due diligence, bidders should try to assess this, analysing fluctuations with reference to trading levels. It should also be possible to benchmark performance of the target against other businesses within a peer group. Achieving performance in line with the average of the peer group as a target, with the performance of the upper quartile as an aspiration, should present a good idea of cash release opportunity once the deal is complete. For more information on BDO’s proprietary working capital benchmarking, please contact an advisor below.

Pre-deal (sell-side): This will very much depend on the time you have in which to prepare the business for sale. If you have good visibility and can prepare over a 12 month period, there may be some strategic levers which can be pulled. For those where there is 6 months or less, more short-term, tactical levers can be implemented to help boost the management accounts. Examples of this include collections campaigns, including disputed invoices, the reduction of safety stock and replenishment parameters, through to more rigorous control of payment runs and cash outflows. Time will dictate the availability of options to generate a positive story in relation to working capital management.

Post deal: Looking at this from the angle of a PE house, many over the last 12 months have grouped investments into 3 categories; stressed, resilient and growth. This is mainly driven by the sector in which the investment operates and working capital optimisation measures required for each will be different.  Whether looking to create value in a new investment or maximise the value from an integrated business it is fundamental that cash is one of management’s top strategic priorities.

Below we have suggested 10 considerations when looking to optimise working capital:

  1. Strategic priority – Cash and working capital management must be one of your businesses Top 3 strategic objectives to generate buy-in top down
     
  2. Transparency – Reporting and analytics will be key to actively track performance, building an accurate view so your business has the management information required to make more informed decisions in a timely and agile manner is important
     
  3. Target setting – Working capital reduction targets should be in place, either based on historical best performance or to come in line with peers. Some even look to aspirational target setting
     
  4. Governance – Working capital is not just the responsibility of the Finance Director. Ensuring, through reporting and a defined forum, performance is reviewed and continuous improvement actions are implemented across the business will build momentum
     
  5. Incentivise – Introducing incentives outside of the executive team is a crucial component to improving performance and is the most effective way to drive change through improved behaviours
     
  6. Roles & Responsibility definition – Creating a clear RACI (responsible, accountable, consulted, informed) matrix is a great opportunity to involve everyone in optimising performance, it also helps people to understand how their actions impact the cash position and can be supported by effective communication and training
     
  7. Target Operating Model (TOM) – Along with a clearly defined RACI matrix, the operating model of the Finance Function needs to be well defined to ensure optimal performance
     
  8. Enablers of a TOM – TOMs can be optimised by ‘enablers’ such as improved systems infrastructure and enhanced employee skill sets
     
  9. Supply Chain Financing (SCF) – Corporate Social Responsibility is becoming an increasingly important component of organisational culture and SCF can be a good way of supporting supply chains by giving smaller businesses access to cash and additional financing on the credit rating of their buyer
     
  10. Cash flow forecasting and scenario modelling – Short-term cash flow forecasts are critical for most businesses. Using the current climate to engage those across the business to support the forecasting process can help improve its accuracy and create overall buy-in

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.