This post belongs to a series on Working Capital (see the contents page here).

The working capital profile of a business can either deliver an ongoing surplus of cash (above earnings) or can cause an ongoing drain of cash (below earnings)

This first diagram shows a situation in which there’s a cash drain on the business in question. If the business is selling its goods for more than it paid for them, then the cash drain is less than the cash expected to be received, but it’s the timing that we’re most concerned with. If the costs must be paid now but revenues are received in 11 months, an accountant may call this profitable, but the business may not be viable in a realistic sense.

Especially in a high growth business, it can be difficult to sustain a cash drain, even for a few days (think millions of dollars for a business that is too early stage for traditional sources of funding).

The second diagram shows a business with a working capital cash surplus. This occurs because it receives cash from its customers before it has to pay its suppliers. This is a nice position to be in, but is difficult to achieve. If a business has a unique position (usually if it accounts for a large portion of supplier sales) it can enforce longer creditor days. Sometimes just the nature of a particular market (such as insurance) will support this type of working capital profile.

A cash-negative working capital position (the first diagram) means that money is tied up, which incurs an interest charge if it’s borrowed or an opportunity cost otherwise.

A cash-positive working capital position (the second diagram) means that surplus cash is available, for a short period, which may produce interest income or allow for other profitable investment.

There are businesses operating right now that have such large negative working capital positions that the ongoing shortfall is greater than the earnings multiple valuation of the business. In these cases, you really must question whether the business is viable in the long term. On the flipside, businesses that have large positive working capital positions can continue to create income from non-operational activities (such as investment), which is the premise behind the float of insurance companies and arguably a big factor in Buffett’s wealth today.

This post belongs to a series on Working Capital (see the contents page here).

It’s quite difficult to understand why working capital is important and why it influences other analyses without understanding its drivers. By understanding each driver, you’ll gain an appreciation for why a movement in working capital may indicate a myriad of potential issues or outcomes.

For example, an increase in working capital may refer to revenue growth, stubborn debtors, stricter creditors, slower inventory, assets sales, or even debt reduction.

The primary drivers of working capital are as follows (see the diagram for more detailed conceptual drivers of working capital):

• Debtors (accounts receivable) – this refers to accrued revenue/sales placed on credit and awaiting to be settled by cash. An increase in debtors may refer to a growth in revenue, a change in debtor terms or difficulty in collecting cash from debtors.
• Inventory (stock) – all materials used to create products (or support services) are considered inventory. Good management of inventory is all about efficiency; how little has to be held, how quickly can we use it, how best can we store it, and what’s the cheapest way to manage it? An increase in inventory can refer to revenue growth, slower moving stock, revaluations, increased obsolescence, or preparations for volatility.
• Creditors (accounts payable) – simply the opposite to debtors; any accrued expenses for payment in the current period but as yet unsettled for cash. An increase in creditors may refer to increased creditor terms, an inability to pay, revenue growth (therefore, increased COGS), increased short-term debt, or higher unearned revenue (prepayments by customers).
• Cash – as discussed in the Working Capital Series: References and calculations, we exclude cash from our analysis because it is the cash requirement itself that we’re attempting to determine. Just think of cash as the plug. If we estimate that worst case conditions show a shortfall of $1m in cash, then we must arrange to have that cash on standby or at least have contingencies to deal with the shortfall (such as renegotiated creditor terms).
• Other - There are other minor drivers of working capital, which include any current account (on the assets or liabilities side) that isn’t included above. If the business has a large debt burden, the current portion of debt may be a major working capital driver. Prepayments, unearned revenue, taxes, provisions, etc. should certainly be considered and included in your analysis if they seem to be volatile and influential.

The typical strategy with working capital is to decrease debtors terms, decrease inventory requirements and increase creditors terms in order to manipulate the working capital profile of the business. If optimised (debtors pay much earlier than you have to pay creditors), you’ll find a cash flow surplus opposed to a shortfall.

However, if most accountants saw creditors ballooning and debtors shrinking, their last thought will be of your credit term negotiating skills. Most likely, they’ll warn you of insolvency. In actual fact, what may look like an increasing need for cash could really be a surplus of cash created by your improved working capital profile.

So as you can see, it is critical to understand working capital drivers in understanding how a business operates from a financial perspective. In the next post of the series, I’ll show working capital profiles in illustration and you’ll see why Buffett was first drawn to insurance companies many years ago.

This post belongs to a series on Working Capital (see the contents page here).

When we talk about working capital in private equity, we may be referring to the financial monitoring value (current assets – current liabilities) or the financial analysis value (current assets – cash – current liabilities).

When monitoring a business, we want to know if it is solvent; that is, whether the business can cover its liabilities. Cash is important in this monitoring because it makes up for any shortfall between assets and liabilities as they fluctuate somewhat independently. If working capital turns negative, we immediately know more cash must be injected to make up the shortfall, otherwise the business is at serious risk of bankruptcy.

However, when conducting financial analysis (rather than monitoring), we’re interested in understanding how much cash a business needs to support its operations on an apples-vs-apples basis. That means, we must exclude cash when looking at movements in historical working capital because we want to gauge how much cash would have been needed, not how much was actually in the bank. Just imagine, a company could borrow money, raise equity, sell assets, or any other number of things that can move cash and skew historic analysis of working capital. So, we circumvent these aberrations by conducting analysis on an ex-cash basis.

One more point though… an analysis of working capital may only include debtors + inventory – creditors if the analyst wants to understand working capital on a purely operational basis. The difference between this and the current assets – cash – current liabilities method, is that minor current accounts are excluded, such as current debt, prepayments, deposits, etc. This may be done to ignore capital structure (current interest due) or if the minor current accounts are insignificant.

So please keep all of this in mind when you hear the term working capital. If an accountant asks about working capital, it’s likely they’re talking about CA – CL. But, if an analyst mentions it, they’re likely referring to an ex-cash calculation. One is to gauge solvency and the other is to understand cash requirements based on business growth, credit terms and volatility.

This is the first post in a series that discusses working capital. The purpose of the series is to deliver a congruent and clear theory on how working capital fits into a private equiteer’s analyses. I plan to make practicable and thoughtful points that (hopefully) don’t regurgitate finance textbooks. So, if deep down, working capital is still a little bit of a mystery to you, stay tuned.

The series will broadly adhere to the following structure:

1. Overview - working capital fundamentals that will provide a foundation for more complex discussions
2. Dealmaking - working capital analysis conducted for valuation and settlement purposes
3. Investees - working capital issues for investees including improvements and monitoring
4. Exiting - working capital considerations when exiting an investee

Although the generic working capital formula is hardly rocket science, it can be quite difficult to understand its exact dynamics in relation to valuation methodologies and other private equity topics. In some instances, it is vitally important to consider working capital, whereas in others it doesn’t really matter (more on that later in the series). Lastly, more than working capital itself, it is critical to understand its drivers and their own influences on value and ongoing performance.

Working Capital Series – Table of Contents

Overview

• Working Capital Series: Introduction
• Working Capital Series: References and calculations
• Working Capital Series: Drivers
• Working Capital Series: Positive and negative profiles

Dealmaking

• Working Capital Series: Valuation
• Working Capital Series: What to do at settlement?
• Working Capital Series: Locked-box approach

Investees

• Working Capital Series: Measuring and monitoring
• Working Capital Series: Improvements and one-off cash wins

Exiting

• Working Capital Series: Preparing for sale

I’ll update the Table of Contents with links as I post on each topic. In the interim, I’ve quarantined my previous working capital posts and will re-post them as (and if) they fit within the series. After reading these previous posts in succession, I realised they contradicted each other, but more surprisingly, I realised my own thinking on the subject wasn’t clear. Already this series has provided some clarity.

Founders of potential investees take substantial risks going to the market, sharing information and looking for investors. Oftentimes, they’re required to send intricate details of their proprietary processes, historic financials and industry forecasts to advisers, bankers, private equiteers and even competitors.

It’s no wonder then, that some founders can be extremely precious about confidentiality. Not only due to competitive threat, but also due to the potential damage of critical relations.

Concerns around confidentiality arise when private equiteers ask founders for customer, supplier and employee contact details. Most of the DD until this stage relates to pieces of paper and historic financials. But, once you have unbridled access to stakeholders, it becomes the real deal. Sure we all sign confidentiality agreements beforehand, but these agreements are little consolation to founders with ruined businesses and without the cash flow to fight a case in court.

(This post actually spawned from an email I received in response to my post regarding market analysis. In that post, I said the best market analysis is done by contacting stakeholders rather than just relying on Google. The reader whom emailed me commented that it’s not so easy to get such access to stakeholders, hence, this post.)

As with most conundrums, there’s a relatively simple solution that entails staging the analysis:

1. In the early stages, contact industry associations, research providers, colleges and then competitors. Be a little careful with competitors; don’t mention the potential investee’s name, try not to mention you’re a private equiteer, and be quite vague regarding the purpose of your call. Also, now’s a good time to advise the potential investee that you will need customer and supplier details soon, so they prepare themselves early to entrust you with that info.
2. The next stage involves retaining anonymity, but reducing the search grid to competitors, customers/suppliers of competitors and maybe even customers/suppliers of the potential investee (if the founders have given approval). The idea of these anonymous calls is to make contact, advise you’re researching the industry and ask broad-based questions about all players in the industry. If they volunteer information on your potential investee, you may feel adventurous and decide to follow their lead with a few brief (and seemingly off-the-cuff) questions.
3. Once the founders agree to you directly contacting customers/suppliers/etc, ensure the questioning guidelines are clear and ensure you make the most of your time with these stakeholders. Keep the founders updated along the way to give them comfort that you’re not ruining their business while they wait in suspense for the outcome. You may also like to make clear the entire plan with them first, even the anonymous calls to associations and competitors.

Market analysis can be tricky because you need to access the people that matter to get the best and most unique information. But, your relationship with the potential investee is also important to the process, so it pays to balance their paranoia with your thirst for information carefully. There’s always a way to work around ultra-paranoid founders, so be willing to give a little.

The best way to calculate capex is by gaining full access to a company’s financial accounts, its financial staff and its executives. With this combination, you’ll be able to paint a good picture of the capex necessary to keep the business running at its current levels of cash flow. However, often we must value companies prior to conducting formal due diligence and in these cases, we typically only have access to standard financial statements. This post discusses calculating capex with access only to these statements.

A few basics first:

• Capex is important because it can significantly influence the value of a business
• We can classify capex as either growth or maintenance, but we’re mostly interested in maintenance capex
• Maintenance capex refers to the capex required to keep a business running at current cash flow levels
• Growth capex refers to capex required to grow the business beyond typical cash flows (e.g. acquisitions)
• Financial statements do not have a line item titled maintenance capex
• And, no formula exists to calculate maintenance capex from the financial statements
• Therefore, maintenance capex calculations are mostly estimates

The first place you may think of looking for data to calculate capex is the cash flow statement (within the investment section). There may be a line item for Investments in Equipment (or similar), which defines cash flow related to investments in assets. While this essentially refers to capex, it will likely include capex related to acquisitions and other growth campaigns. The reason we only want maintenance capex is because we’re valuing the business based on its current state and current cash flows.

The second place you may look for evidence is the depreciation line on the P&L statement. Many people use this as a proxy for capex and cite its smoothing effect as an additional advantage (I wrote about this in a recent post on EBITDA vs. EBIT). However, this smoothing, which accounts for many years, may reflect the business as a different beast because it is backward looking. Additionally, depreciation doesn’t account for asset price inflation, which is significant for certain businesses.

So what else can we refer to? Short answer… nothing. In my opinion, the ideal method for calculating capex from the financial statements is to analyse investing cash flows and depreciation over various years to find trends and arrive at an informed estimate. [EDIT] Also check the supplemental notes for more granular information on cash flows and depreciation (thanks, Scott). Here are a few steps I normally follow:

1. Look at the Investment in Equipment line on the cash flow statement, remove acquisition capex, but make sure to add back an amount that will maintain the newly acquired assets. Look at previous years too; you may find a year without growth and with a similar level of profit, hence, evidence of maintenance capex levels.
2. Look at the Depreciation section of the P&L, increase the amount for inflation, and adjust for structural changes such as acquisitions or major growth into other areas. Again, compare with previous years to find (and understand) abnormalities.
3. Compare the above figures over various years to establish a trend and to help make inferences about what capex should be in future years. Avoid suggestions from management that maintenance capex is some fraction of what you’ve calculated; often managers underestimate capex (edit: managers always underestimate capex).
4. Compare your capex to revenue (and earnings) ratios of listed businesses in the same industry. One would expect similar businesses to spend similar amounts on capex to maintain assets and uphold regular levels of service.
5. Test your calculated figures with management and ask them for specific forecasts on large items. You may find cyclical items that run on a cycle not apparent from only 3-5 years of historic financials. Again, overestimate and make sure the investment is viable on those figures because your overestimation will likely become an underestimation.

Calculating maintenance capex can be time consuming and frustrating, but it is imperative that you understand it in detail in valuing a business. I’ve seen many investments fall short of expectations because private equiteers took management capex forecasts as gospel.

In my last post, I complained about private equiteers talking nonsense when sizing markets. But in this post, I want to be a little more constructive and give you a few of my thoughts on market due diligence.

Private equiteers conduct due diligence on markets for one simple reason: we want to understand customer demand for a firm’s products and/or services. We become ensconced in the security of this demand because it will support future revenue and drive future growth, which underpins future value and decides our investment returns.

Understanding customer demand is quite difficult for most investees; it involves a lot of prodding, poking and probing to gather masses of data, most of which is useless, to make inferences about what customers may or may not do in the future. But as long as you understand it’s not a perfect science, it won’t drive you too crazy.

There are two main objectives in market due diligence:

1. Understanding the market
2. Testing hypotheses about the market

Both of these steps require talking to other people, lots of people… and doing a little textual research on the side. Private equiteers often get too caught up in using Google to understand a market, when really, you have direct access to someone who has operated in this market for many years (the investee’s founder). Additionally, you should see customers, suppliers, competitors, regulators, commentators and anyone else whom has first-hand experience in the market. In comparison to aimless Google searching, you’ll be amazed at the info you can garner from face-to-face encounters with real people.

It’s best to start the due diligence by defining the hypotheses for your investment. Each hypothesis should relate to the question of whether you should invest in the firm. Once you’ve decided what will make (or break) the deal, go about discovering the market while testing the hypotheses. It’s important not to focus solely on the hypotheses, because you’ll be left with a couple of answers and no real understanding of the market. Equally, don’t focus just on understanding the market, because you’ll end up with a pile of information and no clear decision on whether to invest.

During your travels, you’ll find a lot of people that rely on Gartner and other research providers. But, not only shouldn’t you rely on others for such critical tasks, but you don’t want to give up the experience (and resultant knowledge) of rolling up your shirtsleeves, getting your hands dirty, and learning everything about the industry yourself. To really quantify your research, use a bottom-up approach to understand demand, the future spend of customers, your market share, complements and substitutes, opportunities and threats… and then extrapolate to derive estimates on market size and growth. Even if you’re way off, you’ll have at least learned a lot from the experience.

Good luck… and as Steve Blank mentioned in a post today, you can’t test hypotheses from within your building. Get out there!

Normally, private equiteers are calm, controlled and objective when dealing with just about any business issue. They pride themselves on considering the full facts and making carefully measured decisions. But, there’s one certain way to get a private equiteer to leave it all behind and spout a tidal wave of utter nonsense… just ask them to size a market.

A market refers to the total sum of potential buyers for a group of products or services. The market we refer to in private equity is the target market, which consists of buyers actively looking to purchase and whom can afford our type of product or service.

Private equiteers get carried away when sizing markets because they want other partners in the firm to like their new deal and to think the market is large enough to support exponential growth. In many cases, markets really aren’t as large as we hope and there’s no way to measure them accurately, so we embelish a little. But it doesn’t do anyone any good in the long run.

In a previous post (the amplifying effect of diminishing sales), I wrote that even small changes in a market can have a devastating affect on investee equity value. So while exaggerating the size of a market may get a deal done, it will also likely explain why your investee is having a lot of trouble in challenging times or not able to grow in prosperous times.

The step of the market sizing process that allows private equiteers to embellish is the one in which you define the market. For example, does the market for an arborist (tree surgeon) include landscaping? Does it include soil and sand supply? Or to really push the friendship, does it include operating a florist? Although these sound outrageous, I’ve heard it all before and I’ve seen partners regularly lap up the reasoning behind these claims.

The way to get around this embellishment is to understand the different levels in a market and be honest with yourself about how each relates to the firm in question; the levels include the following:

• Penetrated market – this includes the buyers that the firm is currently servicing
• Target market –  this is the market segment that the business has targeted for strategic reasons; it is bigger than the penetrated market because it includes those customers that haven’t bought from the firm
• Available market - this market includes all buyers whom want and can afford your product/service; it is larger than the target market because it includes segments that the firm has labelled as a lower priority
• Potential market – this includes all of the buyers who need or want your service, but that can’t necessarily afford it or don’t have access to buy it; sometimes regulations or other restrictions also keep buyers out of reach

Personally, I think that sizing a potential investee’s market should focus between the available and target markets. However, most analysis I see goes way out of even the potential market and includes groups of products or services that would require new acquisitions, new people, new skills and new experience to even contemplate servicing the market. If you want to conduct honest analysis, stay within your potential market and limit your sizing to the available market.

I read a memorable quote in the Harvard Business Review recently:

all too often [due diligence] becomes an exercise in verifying the target’s financial statements rather than conducting a fair analysis of the deal’s strategic logic and the acquirer’s ability to realize value from it

Unfortunately, this is supremely true; due diligence is often just a triviality. If you don’t believe me, ask a private equiteer how many times they’ve binned a deal due to new discoveries regarding the fundamentals of the business. And you can’t really blame them; they’re incentivized by carry, and carry is just as easily created from financial engineering as it is from long-term value creation. Therefore, it often becomes more about closing deals than closing quality deals.

But, it doesn’t have to be this way, and it shouldn’t. The same Harvard Business Review article suggests asking yourself four questions:

• What are we really buying?
• What is the target’s stand-alone value?
• Where are the synergies—and the skeletons?
• What’s our walk-away price [and what findings would see us walk away]?

I believe you need to define the hypotheses for investing early in the process. Then, decide what findings would lead to pulling out of the deal. Finally, conduct the analysis to test the hypotheses and determine whether the deal should continue. The DD process should be methodical and purposeful if long-term value creation is the goal. If it’s not, then ignore this post and keep closing those deals.

Then again, who am I to edify the private equity community on long-term value creation. I suppose I’m directing this sermon more at those looking to become uniquely differentiated private equiteers. And trust me when I say, you will be unique if you conduct purposeful due diligence. Like a straight cop in a corrupt precinct, try not to let the financial engineers in this industry deprave you.

In one of my previous posts (apparently everything is counter-cyclical now), I talked about approaching potential investees and hearing that almost all of their businesses were counter-cyclical. Of course I was sceptical, and of course, the chickens have come home to roost now.

Implicit in this theme is the concept of correlation vs. causation. That is, the difference between a) two correlated variables, and b) one variable causing another variable. Some business owners would see a drop in economic growth and then an increase in their sales and assume their business was counter-cyclical. This is a simple correlation test. But thinking along the lines of causation, maybe a drop in GDP doesn’t lead to an increase in motor yacht sales or beach homes. Maybe the correlation was simply the result of a lag or government deficit spending. 

So today’s hint (to self and others) is to consider causation rather than correlation. Moreover, don’t be bedazzled by statisticians with regression models claiming causation. Use some common sense and don’t be too afraid of relying on impartial anecdotal evidence. You may have learned to live and die by facts in b-school, but we all know the importance of gut feel.

Remember my post titled The devil’s in the detail? Well, part of being diligent with detail is understanding each and every line of detail. Understanding each line means you can pinpoint problems and create surgical solutions. For example, if you find that gross profit is much lower in one region than the others, you know that you have to investigate COGS in that region. I realise that this is topic is Financial Accounting 101, but like many things, it’s worth being said for the reminder. So without further adieu, here’s how a dollar of revenue turns into less than a dollar of NPAT:

• Revenue (or sales or turnover or the “top line”)
• minus Cost of Goods Sold (or COGS or variable costs)
• = Gross Profit (or GP)
• minus Expenses (or overheads or operating costs or fixed costs)
• = Earnings before Interest, Tax, Depreciation & Amortization (or EBITDA)
• minus Depreciation & Amortization
• = Operating Profit (or OP)
• plus/minus abnormal revenue/costs
• = Earnings before Interest & Tax (or EBIT)
• minus Interest of debt
• = Net Profit before Tax (or NPBT)
• minus Taxation
• = Net Profit after Tax (or NPAT or NP or the “bottom line”)

This post follows on from these previous posts:

• What’s the deal with capex anyway?
  
• Free cash… flow, a primer
  
• The free cash flow capex conundrum
  

In all of my posts about FCF, I haven’t yet mentioned why investment bankers and private equiteers don’t use FCF in practice. Well, FCF is still too “bottom line” for business valuation. It includes taxes and, depending on what version you use (there’s FCF, FCFE & FCFF), it can still be swayed by capital structure. This is why good ol’ EBITDA still forms the basis of most valuations.

However, EBITDA isn’t the perfect measure either; it is still an accounting construct. The advantage of EBITDA over FCF/FCFE/FCFF is that it is independent of depreciation, cost of capital (such as interest on debt) and taxes. The disadvantage of EBITDA is that it doesn’t account for capex, which is a vital driver to ongoing earnings. The other difference compared to FCF, is that EBITDA still includes accrued debtors and creditors. However, for the purpose of business valuation, this is a better representation of the future (as long as there’s no fraudulent manipulation) because accrual accounting is forward looking.

The implication of the capex omission (from EBITDA) is that the EBITDA of one business doesn’t compare well to the EBITDA of another business; the reason being that each may have different capex profiles. In a previous post, I explained that we can’t just use historical capex to adjust FCF (or in this case EBITDA), because it usually contains one-off items. So, what many people do is use EBIT as their earnings proxy because it accounts for capex via depreciation (the argument being that depreciation is a good proxy for capex). Of course, this is fraught with danger because the past isn’t the future and the future isn’t the past. If anything, most businesses will spend more on capex than they depreciate as they grow and enter different industries.

Unfortunately, the solution isn’t so simple. In my opinion, the best earnings measure to use for business valuation is a maintainable and forward-looking EBITDA figure adjusted for the capex required to operate the business under normal conditions. Most of the work will probably go into understanding the real capex position of the business, but at least you can sleep well knowing you’ve invested on robust, rigorous and realistic analysis. So just to recap, the potential measure for earnings when calculating value includes:

• NPAT - almost never used, too “bottom line” and a pure accounting construct
• FCF - still too “bottom line”, capex is often backward looking, rarely used in valuation
• EBITDA - ignores capex, which is an absolute sin, but this measure is commonly used
• EBIT - ignores the evolving nature of capex, sometimes used, 2nd best of many bad options
• EBIT-DAC - can still be manipulated by accruals, but the best of a bad lot

For the record, in Europe, EBITDA minus capex is denoted as EBIT-DAC or EBITDAC.

I recently posted a primer on Free Cash flow (FCF). In that post I discussed why FCF was a superior measure of profitability (compared to NPAT), but I also warned it isn’t a perfect measure. Its virtue is that it better reflects reality by undoing the manipulation of accrual accounting. So, in theory, FCF should more closely reflect your incremental cash at bank.

While FCF may be a better measure of cash profitability, it still has shortfalls for the purpose of business valuation. The chief reason is that FCF is calculated on an ex post basis; it uses historical data. Business valuations, on the other hand, implicitly need to be forward looking. The simple solution is to synthesise FCF based on forward looking assumptions.

One of the major considerations in synthesizing FCF is that the result should be reflective of the ongoing earnings of the business; that is, excluding abnormal and one-off items. The beginning profit and working capital figures can be relatively easy to adjust in this respect, but capex can be more of a red herring. This is because historical capex figures include expenditure on maintain existing assets, expenditure on assets to grow, and expenditure implicit in making business acquisitions. The latter certainly shouldn’t be included in your synthesized FCF because it isn’t reflective of daily operations.

With this in mind, you need to have a detailed discussion with management regarding the level of capex that is required for the ongoing operations of the business. This means reversing out capex from acquisitions and making sure you’ve accounted for enough capex to purchase/maintain the assets required for normal operations. Without this, you can’t hope to arrive at a figure that is reflective of the real ongoing earnings of the business.