The Significance of Working Capital in Company Valuation: A Private Equity Perspective

The moment of exit is pivotal for private equity investors to measure the true value of their investment. While substantial time and effort are invested in refining strategies and fostering company growth, one critical factor often gets overlooked: working capital. This capital, tied up in daily operations, can be crucial when it's time to exit and maximise returns. Effective management and optimisation of working capital can significantly influence the company's valuation, distinguishing between good returns and exceptional ones.

In this blog post, we delve into the importance of working capital, why its management is essential, how it impacts a company's financial health, and how it can enhance the value of your business at the time of exit. 

Market Overview 

As the year-end approaches, the stabilisation of inflation and interest rates has begun to manifest, yet their impact on transaction volumes remains unclear. Concurrently, private equity firms have record levels of unallocated capital, known as "dry powder." This means investors have substantial funds waiting for suitable investment opportunities. In the current market climate, private equity investors have been relatively passive due to higher interest rates and uncertain economic outlooks. They are reluctant to sell their best assets under prevailing market conditions. (PwC, Finnish M&A Market Update 2023) 

Smaller transactions continue to dominate the Finnish market, but larger deals are being prepared as the economic outlook stabilizes. Private equity investors are closely monitoring the market, with several mature companies in their portfolios ready to be sold once conditions improve. The first quarter was strong for the European IPO market, with the highest IPO proceeds since Q1 2021, led by two major private equity-backed IPOs. While IPO activity in Finland is historically low, Europe is recovering, and many companies are preparing for listings in Finland. (PwC, Finnish M&A Market Update Q1 2024) 

 Current valuation levels in Finland are the lowest in years, reflected in EV/EBITDA and P/E ratios. Low valuations do not motivate companies to go public, and sellers are unwilling to part with assets at current prices. From a buyer’s perspective, however, the market situation is attractive. Due to lower valuations, the proportion of earn-outs tied to future profits has increased in M&A transactions, helping bridge the gap between buyer and seller valuation expectations. Current valuations make public tender offers (PTO) appealing but require above-average premiums. Lower valuations lead to higher premiums in PTOs. Although there are relatively few tender offers in Finland, premiums cannot be directly inferred from valuation levels alone. Investors are willing to pay more for high-quality companies, and competitive situations drive up the offered price, overall affecting median premiums. (PwC, Finnish M&A Market Update Q1 2024) 

Working Capital 

Working capital represents the capital required for daily operations. It measures a company's assets and its ability to meet short-term liabilities and finance operations. Simplified, working capital is the amount of cash needed to run daily operations. Companies that tie up less working capital are more profitable, making working capital optimisation crucial for competitiveness.  

Measuring and optimising working capital 

Working capital can be measured and expressed either in monetary terms or as a percentage. The amount of capital tied up depends on the nature of the business but can be significantly influenced by operational practices and processes. When examining working capital from a company’s perspective, it is more important to focus on changes over time than the absolute amount in euros or percentages. Additionally, it is essential to consider how current practices will affect working capital development in the future. Monitoring changes is crucial for assessing the amount of capital tied up in operations. 

Terms often encountered in working capital discussions include net working capital and operational working capital. These terms are sometimes used interchangeably, but they mean slightly different things. 

Net Working Capital (NWC): This typically includes inventory and accounts receivable, minus accounts payable. 

Operational Net Working Capital (ONWC): This includes inventory and accounts receivable, plus any advances paid, minus accounts payable and advances received. 

In simple terms, the smaller the working capital, the better. In other words, the less cash needed to run the business, the more profitable it is, and the better it can respond to changes without facing a cash crisis. By this logic, inventory and accounts receivable should be optimised, and accounts payable should be increased to reduce working capital. 

Inventory can be reduced by improving inventory turnover rates and implementing just-in-time inventory practices. Accounts receivable can be reduced by shortening customer payment terms and improving collection efficiency. Accounts payable can be increased by negotiating longer payment terms with suppliers and optimising the payment process. Prepayments are also important in cash management: prepayments to suppliers tie up cash, while prepayments from customers improve cash flow and reduce net working capital. 

Improving working capital 

Improving working capital is a marathon, not a sprint. It is a comprehensive task that takes time, and indicators may temporarily move in the wrong direction before the desired reduction in working capital is achieved. Optimising working capital should be an ongoing process rather than a one-time project. Working with an experienced partner can help you get off to a strong start and avoid many pitfalls. 

The more systematically companies focus on the management of working capital tied up in operations, processes, and metrics, the less capital is usually tied up. Enhancing working capital can significantly improve business profitability. 

Increasing Company Value Through Working Capital 

Net working capital (NWC) is a crucial factor in determining a company's valuation. NWC is calculated as current assets (inventories and receivables) minus current liabilities (payables) and indicates a company's operational liquidity. This chapter discusses how NWC impacts cash flow and valuation methods and presents strategies to increase a company's sales price by effectively managing NWC. 

Cash Flow Impact 

Net working capital directly affects a company’s cash flow in several ways: 

Free Cash Flow (FCF) 

• FCF is calculated as operating cash flow minus capital expenditures and the change in the net working capital. 
• Impact: A high NWC means more capital is tied up in accounts receivable and inventory and less in accounts payable. This reduces the free cash available after accounting for operational and capital expenditures. Efficient NWC management increases FCF by reducing the cash tied up in operations, leading to a stronger cash position and potentially higher valuation. 

Operational Liquidity 

• Positive NWC: Ensures the company can meet its short-term obligations without needing additional financing. This stability is favourable for investors as it reduces the risk of financial distress. 
• Negative NWC: For Net Working Capital, this indicates potential liquidity issues, making the company more reliant on external financing, which can be costly and risky. However, for Operational Net Working Capital (ONWC), a negative value can be advantageous as it indicates that operational activities do not tie up cash, reflecting efficient management and freeing up cash for other uses.  

Cash Conversion Cycle (CCC) 

• Components: The Cash Conversion Cycle is comprised of the time taken to collect payments from customers after a sale (Days Sales Outstanding), the duration inventory remains in stock before it is sold (Days Inventory Outstanding), and the time taken to pay suppliers (Days Payable Outstanding). 
• Impact: A shorter CCC means the company quickly converts its investments in inventory and receivables into cash. Efficient management of CCC improves cash flow and reduces the need for working capital financing. 

Impact on Valuation Methods  

Discounted Cash Flow (DCF) 

• Free Cash Flow to Firm (FCFF): In DCF, the FCFF is discounted to determine the enterprise value. Efficient NWC management increases FCFF by reducing the cash tied up in operations. 
• Terminal Value: Better NWC management can lead to higher growth rates and lower risk premiums, increasing the terminal value in DCF calculations.  

Comparative Analysis (Comps) 

• Liquidity Ratios: Companies with better NWC management often aim to optimize liquidity ratios (e.g., current ratio, quick ratio). However, in practice, these ratios might weaken if the firm reduces current assets and increases current liabilities while using the freed-up cash for other investments. Nonetheless, these ratios remain crucial for investors comparing companies within the same industry. 
• Premium Valuation: Firms with efficient NWC management might command a premium in valuations because they are perceived as lower-risk and more operationally efficient. 

Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) Multiple 

• Higher Multiple: Efficient NWC management can improve EBITDA margins by reducing operational costs related to excess inventory or delayed receivables. Higher EBITDA margins can lead to higher valuation multiples. 

For private equity investors, optimising working capital offers a way to significantly enhance the value of portfolio companies before exit. Efficient working capital management not only improves liquidity and operational efficiency but also makes the company more attractive to potential buyers, maximising investment returns at exit. 

How can we help? 

Knowit Insight can offer private equity firms a comprehensive approach to optimising working capital. We help improve your company's operational efficiency by optimising key processes such as inventory management, accounts receivable, and accounts payable. This frees up significant cash resources that can be used for strategic growth and development. Optimising working capital enhances return on invested capital and cash flow, making the company a more attractive investment and maximising returns at exit. We combine in-depth data analysis with practical consulting to ensure tangible and measurable results. Additionally, we provide long-term support for process improvement, ensuring that your company can adapt to changing market conditions and maintain its competitiveness. 

The significance of working capital in company valuation before a sale cannot be overstated. It reflects the company's liquidity, operational efficiency, and financial health. Optimising working capital can improve cash flow and reduce financing needs, making the company more attractive to buyers, and increasing its value. Private equity investors should focus on working capital management early enough before the exit to achieve optimal value and favourable sales terms. This way, they ensure that the company is in the best possible condition to attract buyers and maximise investment returns.