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working capital

Optimizing working capital

Optimizing working capital

There is a misconception that a focus on working capital denotes a company in peril. This may be true in some circumstances, but the larger reality is that even the healthiest private equity (PE) and pension fund portfolio companies have much to gain by honing in on working capital opportunities before and after a deal.

Looking beyond EBITDA

Typically, PE and pension funds will fixate on earnings before interest, tax, depreciation and amortization (EBITDA) throughout the due diligence process and pay little attention to working capital beyond simple normalization exercises. That makes sense given PE and pension funds are in the habit of wanting to know how much of their cash is going to be tied up in working capital through the lifecycle of owning the company. However, by ignoring the opportunity to optimize working capital and uncover ways to extract additional cash, they are likely to leave money on the table or, more importantly, fall behind competitors who are taking these practices to heart.

Certainly, it pays to look beyond EBITDA. Not only can extracting cash from working capital reduce an organization's reliance on third-party debt (a source of business risk), that cash can also be re-invested into funding long-term growth programs as well as cost-cutting, right-sizing, or operational improvement initiatives.

Creative ways to find capital

Finding that cash is an exercise in and of itself. Many organizations relate working capital management to back-office services – the people that collect receivables, make payments to suppliers, or buy inventory, etc. In reality, every part of the organization touches the working capital lifecycle, from the top of the house to those back-office functions. Therefore, extracting cash from working capital requires a fulsome review of the organization at a granular level – one that looks beyond the simple stats (i.e. days payable outstanding, days sales outstanding, inventory days) and digs deeper into key functions across payables, receivables, and inventory.

Take, for example, an organization that conducts payment runs once a week on a Monday. Taking time to perform a working capital assessment might reveal that moving the payment run to Thursdays allows the organization to pick up a sizable amount of working capital. Reversely, consider a scenario where the same organization has negotiated an advantageous price for certain goods but has entered into a contract that requires payments every fifteen days instead of thirty. A similar assessment would reveal the amount of cash tied up in working capital as a result of that payment schedule is negatively affecting the organization in the long run. In both hypotheticals, a meaningful investigation of working capital would reveal opportunities to create (or protect) portfolio value.

A new perspective

Working capital optimization is not a practice for stressed or under-performing companies alone. Fortune favours the funds that conduct working capital opportunity assessments prior to a deal or working capital diagnostics in the weeks and months after a purchase. Not only do these exercises help free up cash for re-investment (which can directly impact EBITDA), but they identify upsides that can give PE and pensions funds a competitive advantage in the deal process by allowing them to price some of that upside into the purchase price. And in the end, isn't that what we are all here to accomplish?

And when you are ready,

Let's do this.