How working capital affects a manufacturing business valuation

What counts as working capital in a manufacturer?

Trade working capital is the money tied up in running the business day to day: what customers owe, what is sitting in stock and on the floor, less what is owed to suppliers. For valuation and sale purposes it normally excludes cash, borrowings, tax balances and loans to or from shareholders, because those are dealt with separately when enterprise value is converted to the value of the shares.

Manufacturers carry more working capital than most businesses, and in more forms. Steel coil, resin, film and components arrive weeks or months before the product is sold. Jobs sit on the floor half built. Finished goods wait in the warehouse for a customer's call-off. Large customers pay on long terms. Each piece carries its own risk, so we look at them separately.

Why does working capital change the price?

An earnings-based valuation assumes the business holds the working capital it needs to produce those earnings. It is part of the enterprise, not an extra. If a buyer takes over a manufacturer whose stock has been run down and whose suppliers are owed more than usual, the buyer has to put cash in on day one just to keep production running. That cash comes off the price.

The reverse also applies. An owner who leaves more saleable stock in the business than it normally needs can be paid for the excess, but only if it really is saleable and the sale agreement says so. Stock a buyer does not want is not excess working capital. It is a disposal problem.

Owners sometimes collect debtors hard and delay supplier payments in the months before a sale to take cash out. A properly drafted price mechanism catches that. So does a valuation that states its working capital assumption, which ours does when the purpose is a business sale or an acquisition.

How is a normal level of working capital set?

Not from the year-end balance sheet. Thirty June is a single day, and for many manufacturers it is not a typical one. Businesses supplying agriculture, building products or seasonal retail build stock ahead of their peak and collect cash after it. A large order shipped on 28 June can move debtors by hundreds of thousands of dollars.

We start with month-end balances over at least twelve months, and preferably twenty-four, then adjust for things that will not recur: a stock build before a supplier's price rise, a disputed debt, a one-off contract. We also allow for growth. A business growing quickly needs more working capital every year, and a normal level set on last year's average will be too low for next year.

A GST trap in debtor days

Debtor days are usually calculated as trade debtors divided by annual revenue, multiplied by 365. In Australia, revenue in the accounts excludes GST while trade debtors include it, because GST of 10% is charged on most sales. Unless the debtors are adjusted, the business appears to collect more slowly than it really does.

Why is work in progress the hardest number to rely on?

Make-to-order and engineer-to-order manufacturers, such as builders of conveyor systems, switchboards, trailers, process skids or special-purpose machinery, carry work in progress measured by their job costing. The figure depends on how labour and overheads are absorbed into jobs and on whether each job will finish at a profit. Neither is visible from the balance sheet.

AASB 102 Inventories requires inventories, including work in progress, to be measured at the lower of cost and net realisable value. Net realisable value is the expected selling price less the estimated costs to complete and sell. A job quoted too low, or running over its hours, should be written down. In smaller businesses that rarely happens until the job closes, so the loss sits in work in progress until then.

Progress billing pulls the other way. Where a customer has paid a deposit or been billed ahead of the work, the business is holding the customer's cash. A buyer who has to finish the job wants either that cash or a matching adjustment. Whether deposits are treated as working capital or as debt-like items is one of the most argued points in manufacturing sales, and it has to be decided the same way in the valuation, the target and the completion accounts.

For each open job we look at the contract value, costs to date, estimated cost to complete, amounts billed, the margin compared with the original quote, and how long the job has been open. A job list where the oldest jobs carry the most cost usually tells its own story.

How are slow and obsolete stock treated?

Many smaller manufacturers carry stock at cost with no provision for lines that have stopped moving. Others write stock down for tax. Under the Income Tax Assessment Act 1997 (Cth), each item of trading stock on hand at year end can be valued at cost, market selling value or replacement value (s 70-45), and a lower value can be elected for obsolescence or other special circumstances if it is reasonable (s 70-50). The stock figure in the accounts may therefore reflect tax choices rather than what the stock will sell for.

We work from a stock ageing by line. The items we look at most closely are:

• stock with no movement in twelve months or more
• customer-specific stock, such as printed packaging, branded components or parts made to one customer's drawing, which is worth something only while that customer keeps ordering
• spare parts for machines that have been sold or scrapped
• raw material bought in bulk to secure a price, where the quantity is far above normal usage

In a sale, slow stock is either written down or excluded from the working capital target and the price. Owners who clean it up before going to market are better placed. A write-down taken a year earlier is a known item that is normalised out of the earnings. One discovered in due diligence becomes a negotiation about what else has been missed.

What do debtors and creditors tell a buyer?

A debtor ageing shows more than collection speed. It shows which customers pay late, which invoices are in dispute and whether retentions are held on project work. A manufacturer supplying national retailers, builders' merchants or mining companies may be on long payment terms, and those terms are part of the real price of the contract.

For large customers there is public evidence. Under the Payment Times Reporting Scheme, businesses with total income over $100 million report how long they take to pay their small business suppliers, and the reports are published on a public register. A buyer can check whether a manufacturer's biggest customer pays on time, and so can a valuer.

Creditors need the same scrutiny. A business paying suppliers at 75 days on 30-day terms is borrowing from them, and a new owner cannot rely on that continuing. Overdue tax and superannuation are not trade creditors at all; they are debt. Where much of the revenue comes from a few customers, debtor risk and concentration risk overlap, which our article on customer concentration covers in detail.

How do working capital targets and completion accounts work in a sale?

Sales of private manufacturers are commonly priced as an enterprise value on a cash-free, debt-free basis with a normal level of working capital, and the price for the shares is worked out from there. There are two usual ways to do it.

• Completion accounts. The parties agree a working capital target, often called the peg. After completion, accounts are drawn up at the completion date. If working capital is below the target the price falls by the shortfall; if it is above, the price rises, often subject to a cap. Net debt at completion is deducted dollar for dollar.
• Locked box. The price is fixed by reference to a balance sheet at an earlier date, and the seller promises not to take value out of the business between that date and completion, other than agreed payments. There is no adjustment after completion, so the checking happens before signing.

Disputes come from definitions more than arithmetic. Is a customer deposit working capital or debt? Is the stock provision in the completion accounts calculated the same way as in the accounts used to set the target? Is a long-overdue debtor included at full value? Each answer should be written into the agreement, and the valuation should use the same definitions. If the valuation assumed one level of working capital and the agreement uses another, the two no longer describe the same deal.

What should a manufacturer prepare?

1. Month-end balance sheets for the last 24 months, not just the year-end accounts.
2. A stock ageing by line, with customer-specific and slow lines flagged.
3. An open job schedule showing contract value, cost to date, estimated cost to complete, billing and margin against quote.
4. A debtor ageing with notes on disputed and retention amounts.
5. Supplier terms for the main creditors, and a note of anything paid late.
6. A list of customer deposits and progress billings, and how each has been recorded.

The valuation readiness check covers the rest of what we usually need. For the wider picture of how a manufacturer is valued, see our manufacturing business valuation guide, and for the earnings side, EBITDA vs EBIT in industrial valuations.