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09 February 2021

Corporate Finance: How To Triage The Working Capital Cycle During Covid?

FPM Senior Manager Ashok Thomas shares practical insights on dealing with the Working Capital Cycle adjustments in a transaction during the COVID-19 pandemic.

The Emergence and Patient Zero

Our Corporate Finance team was advising an overseas buyer on the purchase of an Irish electrical control system manufacturer at the beginning of the COVID-19 lockdown when we observed a sizeable growth in the target company’s bank balances which didn’t really correlate to the operating activity during the period.

A detailed analysis of the cash flow movement revealed that when the company ceased trading at the start of lockdown it converted most of its working capital into cash. As with most transactions, the proposed debt-free cash-free structure meant that the Seller would walk away with the inflated bank balance. Further, the timing of the completion was such that the Buyer would then have to fund a substantial working capital requirement on the imminent re-start of work.

I could rattle on with at least half a dozen more examples on how erratic working capital movement during the COVID-19 pandemic resulted in a material adjustment on purchase prices, but the unmistakable takeaway is that working capital needs more attention than ever.

Known Symptoms and Diagnosis

I am a bit of a geek when it comes to the working capital and confess that I thoroughly enjoy discussing the intricacies of the working capital adjustments with our clients.

Working capital is defined as the operating liquidity available to a company. It is usually calculated as current assets (excluding cash) less current liabilities (excluding debt). But the specific calculation of working capital for a transaction is defined in the share-purchase or asset-purchase agreement.

When we talk about the ‘working capital cycle’, we are referring to the amount of time it takes to convert the net current assets and current liabilities into cash.

Most deals involve a purchase price adjustment mechanism in relation to working capital. For the Buyer, this ensures that the business will have sufficient working capital to fund its trading cycle from day one of ownership.

Setting a working target protects the Buyer from the following actions prior to sale:

  • Aggressively collecting payments from customers
  • Liquidating stock
  • Slowing payment of suppliers

Early warning signs that could indicate working capital concerns include:

  • Deferred liabilities due to Covid especially PAYE, VAT, and Corporation taxes
  • Changes in the levels of activity over the last year and expected activity in the next 12 months
  • Suppliers asking for advanced payments for future contracts
  • Working capital adjustments made due to furlough and other grants and supports received
  • Extended time to pay given by certain creditors

Possible Treatments

Here are some practical tips to identify potential working capital adjustments:

  • Analyse monthly working capital trends prior to the COVID-19 pandemic
  • Understand how key working capital balances have performed during the pandemic
  • Establish future levels of activity and working capital required to operate at that level
  • For key suppliers understand whether they are likely to modify the credit period due to the pandemic
  • Anticipate future delays and challenges in customer collection
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Improving Efficacy

Like most corporate finance professionals, I have a preferred working capital mechanism, but clearly some methods that work better than others in certain circumstances. Choosing the right working capital mechanism is half the battle.

Working capital adjustments, although difficult to calculate, are easy to explain and understand. Before you throw the book at the other side (The Art of the Deal, of course), I would recommend that advisors approach the issue pragmatically by building engagement and consensus with all sides to ensure they don’t frustrate the already difficult deal closing process.

Contact Ashok

Ashok Thomas / Senior Manager

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