Many companies are beginning to experience a softening in their customer markets, resulting in top-line and margin pressure. For companies in, or embarking on, an M&A transaction, this presents both explicit and implicit challenges.
Earnings before interest, taxes, depreciation and amortization (EBITDA) has for a long time been the barometer of value for privately held, middle-market companies because it is considered a proxy to operating cash flow (absent how the operations are legally or financially structured, hence the removal of interest and tax from the definition).
This notion that EBITDA is a proxy for cash flow may be true over time, but in the short term, several factors usually separate the two. A company going through any degree of change will see swings in working capital and reinvestment of profits and expansion opportunities that will deviate cash from EBITDA, and companies that have meaningful capital expenditures will see more of a consistent deviation over time.
Owners and investors are becoming more and more focused on actual cash generation (rather than EBITDA) as a valuation consideration, not only because it proves out EBITDA over time, but it also highlights the management team’s ability to navigate through turbulence and the nuances of a given business model.
CONSIDER WORKING CAPITAL
This leads us to a discussion on working capital, which can (and does) have an impact on many businesses’ cash flow. Increased prices, longer shipping times and a self-fulfilling prophecy of needing to build inventories to avoid stock-outs all have a compounding impact on working capital needs and a direct drain on cash generation — unless companies can offset with other actions.
Couple this with, say, a small reduction in top line and/or margin, and companies can quickly find liquidity to be a challenge if not properly managed.
Whether currently in an M&A process or not, companies should keep a very close eye on working capital, cash generation and cash management — investing to grow for the future while being mindful of the sensitivities that the current economic climate has on cash generation. Holding excess cash on the balance sheet may be inefficient, yet, holding too little exposes liquidity risks and raises questions about the ability to convert earnings to cash in the long term.
Please contact GHJ’s Transaction Advisory Services team to learn more about this topic and other challenges faced by companies going through a transaction.