The purpose of this article is to demonstrate the real possibility of improving the return on the investment through feasible actions with an important impact.
First of all, if we analyze the origin of the working capital it is obvious that the difference in outstanding days generated by the procurement and sales processes are materialized in financing needs of stocks and receivables which may be or may be not covered by payables. When that is not the case to obtain financing from banks or shareholders will be needed.
So, the structure and dimension of the Working Capital condition the financing needs. But, how this fact affects the value of the company? Through the Enterprise Value Equation.
If we define the value of the company through the equation Enterprise Value = EBITDA x multiplier + (Cash – debt), the working capital variation affects the debt and therefore the valude of the company. Not only in its dimension but as well in relation with its way of financing, which may be favored or penalized by the level of leverage and the possibility of using financing tools related with the commercial operations which may improve the financing mix of the company, the leverage vs equity, and which may facilitate the negotiation with financial entities.
Variations in the working capital may impact positively or negatively during all the life of the investment with changes in each of its components. Those changes don’t have to be very significant to have an important impact on a global basis.
A small improvement, for example of a 5%, in each of them (stocks, receivables, payables and treasury) may even duplicate the cash conversion rhythm. On the contrary, if the organization neglects the working capital management, small deteriorations of each of them are enough to cause that the financing needs grow considerably which is a normal situation in all those moments during the investment cycle in which the management of the company is chasing other objectives such as to increase the sales and improve the margin.
Not only it is possible to identify the causes by which the working capital affects the value of the company, the mechanisms of its variation and how it influences in the financing needs, but it is possible as well to demonstrate empirically that for a specific project, with an established return on investment, without changing the EBITDA, it is possible to multiply that return and increase the IRR with improvements in the components of the Working Capital absolutely reachable by the management of the company, with the necessary guidance.
Possible actions on Working Capital and their impacts are different on each phase of the investment.
* In the pre-investment phase the main actions will be the analysis and diagnosis of the improvement potential, the existing risks and the possible financing alternatives, with an action plan for its execution before or after the take of control.
* In the development phase different strategies for changing the processes, the organization and the information available will be prepared, with periodical and continuous actions on the Working Capital objectives and focusing the whole organization on their achievement.
* In the divestment phase actions which allow to get improvements in the cash generation in a short period of time are to be implemented, impacting accordingly in the valuation of the company.
We are going to develop in detail these three phases, the measures taken and their impact. For that purpose, we will divide in three parts the analysis and will distribute them in three instalments.
Those instalments will be published in successive Newsletters which may be as well consulted in our Web.
Instalment I – Pre-Investment Phase
As it was explained in the introduction, we have divided the presentation of the actions to be taken and their impact on the return on investment, in three instalments, corresponding to the following phases.
In this first instalment we describe the moment immediately prior to the take of control of the company.
This phase is characterized by a progressive access to company data and to the knowledge about the organization and its processes.
It is possible to establish various levels of diagnosis in this progressive knowledge of the Company, starting with some previous conclusions based in basic financial data and market benchmarks, and following with thorough information both qualitative and quantitative which allows the elaboration of a full diagnosis and a possible action plan.
The diagnosis will include a first analysis of the improvement potential of the Working Capital, which has an intrinsic value, and the risks of the same Working Capital regarding its worsening under specific circumstances which may be forecasted. This will provide a first input of the modification of the possible value of the company, positive or negative.
From this study we will get financing alternatives and the possibility to monetize the accounts receivables or stocks, considering the different facilities and its suitability to the actual structure of the Working Capital of the company.
All the identified improvement actions are quantified in this phase and will be included in the financial model which will support the acquisition of the company, at the same level than the operating improvements and the impact of new business developments.
The last task of the work to be done in this phase is the identification of the action plan, which comes as a consequence of the diagnosis.
This action plan may be started before the takeover, with the identification of measures to design the instruments of monetization and the pre-negotiation with the financial entities, and, obviously, from the day zero after the takeover, starting the implementation of the mechanisms identified in the diagnosis.
In summary, it is possible to establish the improvement opportunities of the Working Capital and, therefore, the modifications of the value of the company due to them in the phase of pre-investment, as well as the decision about the available financing alternatives preparing the company for its transformation before or from the first day of the acquisition.
For that purpose, it is required an expert knowledge, a methodology for the analysis and the design of the action plan and the organization capabilities for its implementation.