David Newport: Working capital needs attention

I hate to think how many times a business I have marketed has created problems during the transaction because of its working capital requirements.

Most business owners see working capital as a cost of doing business, while most purchasers (and the financiers) think it needs to be added to the 'list price' to get the true asking price.

In simple terms, the majority of SME sale transactions are completed as asset sales; so, a new owner will buy the assets of the business, including stock, plant and equipment (all fixed assets) and intangible assets, which are everything not on a stock or asset list, such as goodwill.

At settlement, the exiting owner would arrange to have their outstanding invoices collected and pay the creditors due. A new owner would be expected to inject the working capital requirements of his new business, which in normal circumstances would be two to three months' rent, wages, operational expenditure and normal stock orders (if required).

This can be a significant amount of money and often will be tied to the business until the new owner exits, and this is the reason working capital issues can adversely affect the transaction.

It is therefore beneficial for both parties to try to minimise the actual working capital requirements of any target business. Areas to look out for include:

1. Aged debtor report
A business' ability to collect its debtors in a timely fashion, hopefully inside 30 days, improves cashflow and greatly reduces the working capital requirements. If a business can only collect debtors 60 days and over, the owner has to make up the shortfall, thereby increasing working capital.

2. Stock report
If a business has an efficient stock management system, they should be able to increase stock turns and hold less stock on hand at any given time. The more stock on hand, the more working capital required to fund it.

3. Supplier terms and conditions
Many New Zealand business owners operate with very little debt, and the payment terms negotiated with suppliers typically reflect this, with stock often paid on letter of credit, FOB or on receipt of bill of lading. In the case of products coming from China, this means the goods are paid for up to a month before they are available for sale. For a new owner of the same business, who has in most cases borrowed to make the purchase, this can impose huge working capital requirements to deliver products to customers under the same terms and conditions, especially if compounded by a lax debtor book and inefficient stock management system. If you are thinking of selling, try to negotiate more friendly payment terms for a new owner.

4. Progress payments
If it's a manufacturing or projects-based business, including these in the terms of payment will greatly reduce the working capital requirements.

5. Site lease
If selling the business some time within the next renewal of the site lease is a possibility, ensure the size of the site will be suitable for the business in future. If it is a longer-term lease (say a 6 + 6), try to renew for 2+2+2 to give a new owner the flexibility to adjust as required. Paying rent for unused space is a mind-numbing use of working capital.

Even if you are not looking to sell, consider these points. Pulling some working capital away from the business is desirable for any owner.

* David Newport is a principal of business sales & acquisitions firm Switch Business Ltd.