The classic “cash is king” is a horrible cliché. Still, things generally achieve cliché status for a good reason (or two). Companies go bankrupt because they run out of cash, simple as that.
Bankruptcy is one thing. A sub-optimal valuation is quite another. When looking to sell your business or bring in a new partner, everything you can do to increase the value will give you a better long-term financial reality.
You would either be able to raise more capital for the stake in question (because it is worth more) or give away less equity in return for a set amount of capital. Either outcome is good.
But what does this have to do with working capital?
Unless we are talking about Silicon Valley startups that never seem to run out of funders who don’t care about cash flow, most businesses need to generate cash profits.
You may have heard of a metric called free cash flow, which is a critical concept in valuations. This is the core input into a discounted cash flow analysis, which is the most detailed and arguably best valuation method of them all.
By focusing on free cash flow, we can assess whether a business is genuinely generating cash for shareholders. If there’s no cash, there is no investment return.
It’s all good and well to generate profits, but what happens if there are large debtors that take forever to pay? How does it help you to be profitable if you owe your suppliers a fortune long before your customers pay you?
Is a business valuable when all the cash lands in the warehouse, tied up in inventory?
These concepts relate to working capital, the lifeblood of the business. The way cash moves through the system is beyond important, as sales must eventually translate into cash. The inventory policy and the way debtors and creditors are managed will determine how long that takes.
The rule of thumb for a valuation is simple: the shorter the working capital cycle, the more valuable the business.
Why? Because it means that sales turn into free cash flow a lot faster, which is rewarded by investors who love getting higher returns in a shorter space of time. The time value of money is a thing.
There are two areas where cash tends to get stuck in a business: debtors and inventory.
With debtors, it’s important to set fair payment terms and stick to them by collecting cash on time. If terms are too strict, it can harm sales. If they are too loose, it can put the business under stress and negatively impact the valuation.
With inventory, the goal is to have enough inventory to meet client demand, but not so much inventory that the balance sheet is inefficient. There is a holding cost for inventory that goes beyond space and insurance. If cash is invested in goods on the shelf, it isn’t earning a return somewhere else. The art of supply chain management is all about achieving dependable inventory supply in the right quantity.
There is a way to limit the cash flow impact of debtors and inventory. Creditors effectively fund some of that burden by giving you payment terms, which means breathing space to turn inventory into debtors and debtors into cash before needing to pay suppliers.
To shorten a working capital cycle, businesses need to focus on reducing debtors, only having the necessary amount of inventory in stock and pushing suppliers for the longest possible trading terms.
To find out what your business is worth and to test the impact of different working capital assumptions, visit bizval.co and give our algorithm a try. At bizval, we are focused on giving founders access to professional valuation tools at a reasonable cost, something that hasn’t been available in the market before.