Working Capital Management

Working Capital Management Presented By: W. Michael Grady, CPA, CM&AA Managing Director SCACPA 2013 Accounting & Auditing Conference December 5, 2013 Working Capital Management O Defined as the relationship between a firm s short-term assets and its short term liabilities O Goal is to ensure that: O A firm is able to continue its operations O A firm has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses 1

Working Capital Management O Involves managing inventories, accounts receivable and payables, and cash O As real world accountants you all know what a difficult task that can be Working Capital Management O Discussions to Include: O Working Capital Shortages and the effects on operations O Working Capital Management in a Merger or Acquisition Transaction O Working Capital Management and Inventory Control 2

Working Capital Shortages and its Effects on Operations O Income Statement Analysis O 2011 mediocre; $100,000 profit O 2012 improved; $750,000 profit O Reasons for improvement: O Higher sales in 2012 O Higher gross profit % in 2012 O Lower costs for materials & labor O Can you explain what happened? 3

Working Capital Shortages and its Effects on Operations O Balance Sheet shows new PP&E O Results: O Less Material & Labor Cost Per Unit O More Sales Due to Lower Unit Prices O New Products O Looks like a great decision but let s look further 4

Working Capital Shortages and its Effects on Operations O 2011 Balance Sheet - what looks good? O Good debt to equity (2 to 1) O Positive working capital O Majority of book value results from PP&E Working Capital Shortages and its Effects on Operations O What gives cause for concern at December 31, 2011? O Working capital only $300,000 O Weak current ratio (1.27) O Aged payables averaging 90 days O Annual income too small to solve problem 5

Working Capital Shortages and its Effects on Operations O Possible Recommendations at December 31, 2011 O Reduce days to collect AR O Improve inventory returns O Review plan efficiencies O Personnel reductions Working Capital Shortages and its Effects on Operations O How can you find fault in management s decision for new equipment with such immediate positive results in 2012? O Working capital is now negative O AP now over 135 days O $500,000 new short term debt increases risk O Cash flow pressure substantially increased O You were just hired; what are your suggestions? 6

Working Capital Shortages and its Effects on Operations O Solution O Potential Issues: O Bank Overdrafts Long Term Financing with Bank O Poor Payment History on Bank Debt O Poor Credit Ratings with Suppliers O Why is NOW a better (or worse) time than last year to obtain debt? Working Capital Shortages and its Effects on Operations O Options Without Long Term Bank Financing: O Communicate with Suppliers O Obtain Better Vendor Terms O Offer Better Terms for Early AR Payment O Lower Inventory O ABL Lending O Other Debt Sources with Higher Interest 7

Working Capital Shortages and its Effects on Operations O What are future working capital concerns? O Continued growth? O Collecting AR O May need flexible ABL loan O Too busy to properly monitor working capital and operational efficiencies Working Capital Management in an M&A Transaction O Read LOI in Handout O Concentrate on Items 1, 2, 5 and 8 O Seller/Client brings you executed LOI for help O At the time of the LOI, Buyer only received December 31, 2012 statements O Do you see any major red flags in the LOI? O Do you see opportunity for future negotiation? 8

Working Capital Management in an M&A Transaction O In reviewing the Balance Sheets: O No Targeted Working Capital O No Targeted Equity O What would you advise the client? O What are the issues for the Buyer and Seller if there were a Sept. 30, 2013 closing? 9

Working Capital Management in an M&A Transaction O Advice to the Seller Before Closing: O Do not buy equipment O Aggressively collect AR O Allow payables to age (within reason) O Use any extra cash to pay Line of Credit O Make sure all tax distributions are made Working Capital Management in an M&A Transaction O How do your strategies differ with an equity target? O Purchase of PP&E is not an issue O Payment of AR & AP are irrelevant as are other working capital balances O Would paying down the LOC be an issue? O Tax distributions are still an issue O Increased profits are the focus for the Seller 10

Working Capital Management in an M&A Transaction O LOI reflects a stock sale O What are the ramifications of the Section 338(h)(10) election? O Differences for a C-Corp vs. an S-Corp O How would you negotiate for a seller? Working Capital Management and Inventory Control O Control over Inventory is likely the key element in Working Capital Management for a manufacturing company O Concerns over: O Raw Materials O Work in Process O Finished Goods 11

Working Capital Management and Inventory Control O Food Canning Example: O Raw Materials O Empty Cans, Produce, Brine, Labels, Boxes & Trays O Price Variances from Actual to Standard O Yield Variances Actual to Standard O Establish Well Documented Standard Costs Working Capital Management and Inventory Control O Food Canning Example: O Quality Control O Damage, Obsolescence and Other Shrinkage O Establishing Controls O Quantity control from receipt to shipment O Departmental control, both at warehouse levels and on the production floor 12

Working Capital Management, LLC Income Statement For the Years Ended December 31, 2012 and 2011 2012 2011 Net Sales 5,000,000 100.00% 3,000,000 100.00% Cost of Goods Sold Materials 1,500,000 30.00% 1,000,000 33.33% Labor and Related 1,000,000 20.00% 750,000 25.00% Depreciation 300,000 6.00% 150,000 5.00% Other Manufacturing Costs 600,000 12.00% 350,000 11.67% Total Cost of Goods Sold 3,400,000 68.00% 2,250,000 75.00% Gross Profit 1,600,000 32.00% 750,000 25.00% Operating Expenses Wages and Salaries 340,000 6.80% 250,000 8.33% Advertising 150,000 3.00% 100,000 3.33% Insurance 75,000 1.50% 50,000 1.67% Office Expense 60,000 1.20% 50,000 1.67% Other Operating Expenses 85,000 1.70% 75,000 2.50% Total Operating Expenses 710,000 14.20% 525,000 17.50% Net Operating Income 890,000 17.80% 225,000 7.50% Interest Expenses 140,000 2.80% 100,000 3.33% Net Income Before Income Taxes 750,000 15.00% 125,000 4.17% Income Taxes 250,000 5.00% 25,000 0.83% Net Income 500,000 10.00% 100,000 3.33% 13

Working Capital Management, LLC Balance Sheets December 31, 2012 and 2011 Assets 2012 2011 Current Assets Cash 200,000 150,000 Accounts Receivable 800,000 500,000 Inventory 900,000 750,000 Total Current Assets 1,900,000 1,400,000 Property, Plant and Equipment Leasehold Improvements 900,000 500,000 Machinery 2,500,000 2,000,000 Vehicles 400,000 300,000 Office Equipment 300,000 200,000 4,100,000 3,000,000 Less Accumulated Depreciation (1,600,000) (1,300,000) Net Property, Plant and Equipment 2,500,000 1,700,000 Total Assets 4,400,000 3,100,000 Liabilities and Owners' Equity Current Liabilities Accounts Payable 900,000 400,000 Line of Credit 500,000 400,000 Short-term Note 500,000 100,000 Current Maturities of LTD 200,000 200,000 Total Current Liabilities 2,100,000 1,100,000 Long-term Debt, net 800,000 1,000,000 Owners' Equity Capital Stock 100,000 100,000 Retained Earnings 900,000 800,000 Current Year Earnings 500,000 100,000 Total Owners' Equity 1,500,000 1,000,000 Total Liabilities and Owners' Equity 4,400,000 3,100,000 14

Working Capital Shortages and the Effects on Operations To examine and understand the issues related to Working Capital in the Financial Statements, I offer the following notes and comments. 1. First review the Income Statements. 2011 was a mediocre year with profits of $100,000. 2012 showed dramatic improvements with pre tax profits of $750,000 up 6 times over 2011. The major improvements resulted from increased sales combined with significantly higher Gross Profit % (primarily related to efficiencies in materials and labor as a % to Sales). From looking at the Income Statements only, what could have happened to show such improvements? 2. After reviewing the Balance Sheets you can see that the efficiencies resulted from plant and equipment expansions that resulted in less material and labor cost per unit and more sales because of lower unit sales prices or new products from the new machinery. At this point it looks like an outstanding decision to make the expansions. Before we conclude, let s look at the Balance Sheets in more detail and the effects of the company s decision on the financial position and particular the working capital. 3. What about the Balance Sheet looks good in 2011? Good debt to equity position at 2:1. Positive working capital. Book value of the Property and Equipment appears the major reason the company has equity. 4. What about the Balance Sheet gives cause for concern in 2011? Working capital is only $300,000 and current ratio is weak at 1.27. Aged Accounts Payable is already averaging 120 days (90 days past due based on 30 day terms). Operational income will not be enough to improve the company s working capital position. 5. How much cash flow can be achieved by reducing Accounts Receivable from 60 days to 45 days (based on 2011 balances and then based on 2012 balances)? 6. There is not enough information about this business to properly evaluate Inventory and there is no information on the breakdown between raw materials, work in process and finished goods. In 2011 the overall Inventory turn was 3 times which is not good unless the business conditions required this level of turns. It did improve to almost 4 turns in 2012. 7. Even with the large increase in income, the expansion has put more pressure on the company instead of taking the pressure off. Why? Aged Accounts Payable is now averaging over 150 days and the company has borrowed $500,000 in shortterm debt. 15

8. If you were just hired as CFO, what would you recommend? Long term financing to get new capital. How easy a sale would this be to a bank? Except for poor credit ratings with suppliers, it should look good because now the expansion is completed and the results are so positive, you can show pay back with plenty of excess over the standard debt service ratios. Also you should be able to explain issues to the bank and how the loan will get the suppliers current. 9. If you had been the CFO prior to the expansion, what would you have recommended? What would have been the problems at that time that may have caused the bank to turn a loan request down? 10. Again as CFO would you have recommended the expansion if the bank had turned you down? Different opinions are likely. If the decision had been to go forward, steps should be taken to insure suppliers will not put you out of business. My choice would have been to try other sources through some other higher interest scenarios. If these efforts were not successful, I would not have recommended expansion unless the stockholders were CERTAIN of the results and/or willing to take the business under if the expansion did not work. 11. On a separate note, if the company can get suppliers to work with them, the company s profitability may allow them to work out of their problems. 12. But none of the options should be pursued until some expectations of the future are explored. Will there be continued growth? If so, what are the Working capital requirements? And how will you fund the growth? If not (and if growth will continue), what are industry and company expectations as to Inventory turns and average days in Accounts Receivable and what are suppliers expectations for paying their account? 16

Letter of Intent Private and Confidential August 17, 2013 Seller 123 Any St. Anytown, USA Dear Seller: Our review of the information you provided on June 12, 2013 has confirmed our interest in acquiring your business and we are prepared to proceed as quickly as possible with due diligence and the preparation of a definitive acquisition agreement. Pursuant to our ongoing discussions regarding a potential transaction, the Buyer is pleased to submit the following non binding indication of interest (the Proposal ) with respect to the acquisition of Company, Inc. (the Seller ) on the basis of the confidential information provided through the date of this letter. We are prepared to proceed expeditiously with the objective of developing definitive acquisition agreements at the earliest opportunity. We believe the Buyer represents an ideal acquirer of the Seller for the following reasons: Our subsidiary is the leading distributor in our market. We have grown to this position employing a centralized strategy but we are interested in developing a localized presence to serve the market. The Seller is well positioned to allow us to begin the development of this model. We believe the Buyer is best positioned operationally and financially to capture the benefits associated with a dominant market position in the market by using the strategies, tools and experience we have garnered over the past 20 years in executing our strategy in our markets. The Buyer is keenly interested in retaining the management of the Seller and we see this as a crucial element of this proposal. In addition, the Buyer is a strong believer in equity ownership for all employees. We will attempt to design programs that would allow management and key employees of the Seller to participate in future success through equity ownership. 1. Purchase Price Based solely upon the information provided up to the date of this letter, we are pleased to submit a preliminary indication of interest to acquire the stock of the Seller for an initial enterprise value of $4 Million. As the sole shareholder of the Seller, you would receive this amount less Debt of the business. Debt is defined as the balance owed that would be paid off or assumed at closing under the existing line of credit, loans related to vehicles and note payable to employees. 17

2. Conditions Given the nature and extent of the information provided, the Buyer s preliminary offer is subject to the following conditions: a. Satisfactory completion of customary due diligence typical for transactions of this size and type prior to the expiration date of this Letter of Intent. b. Satisfactory negotiation and completion of a definitive purchase agreement and other such agreements as may be necessary prior to the expiration of this Letter of Intent. c. Seller would be operated in the ordinary course through the date of closing of any definitive agreement. This would include the prohibition of any unusual distributions, dividends, loans or cash advances to owners or employees, and any changes in accounting policies or procedures. 3. Non Competition Agreements We expect the shareholders of the Seller to enter into a comprehensive noncompetition agreement at closing that would prevent you from competing with the business for a period of three (3) years. 4. Employment Agreements Buyer considers key employee retention a critical element of the overall transaction and expects to execute satisfactory employments agreements with key employees. 5. Financing We would pay cash and there would be no financing contingency. 6. Timetable We are prepared to move immediately with a view to completing our due diligence, while simultaneously negotiating and finalizing a definitive agreement as promptly as possible. 7. Expiration Date and Exclusivity From the date of acceptance of this Proposal, the Buyer will have the exclusive right to negotiate with you through November 30, 2013 or the mutual termination of discussions via written notification between the respective parties. During that period, neither the Seller nor any of its representatives, directors, officers, stockholders, agents or affiliate will enter into or pursue any discussions or negotiations with any third party concerning the sale or acquisition of the Seller or any material portion of its assets. The Expiration Date and Exclusivity period can be extended through mutual agreement of both parties. 18

8. 338(h)(10) Election It is the Buyer s intent that the acquisition of the Seller will receive 338(h)(10) treatment under the Internal Revenue Code. Towards this end, each shareholder of the Seller shall join with the Buyer in making an election under Section 338(h)(10) of the Code (and any comparable election under state or local law) with respect to the acquisition. The Buyer and all shareholders will cooperate fully with each other in the making of such election including the filing of all required IRS forms and related forms under state and local law. 9. Costs and Expenses Except as set forth in this Letter of Intent, the Seller and Buyer shall each be responsible for its own costs and expenses incurred in connection with all matters related to the transaction contemplated by this Letter of Intent, including without limitation, all accounting, legal, broker and other professional fees. 10. Confidentiality This offer is made on the basis that its existence and content are to be kept strictly confidential and, unless otherwise mutually agreed, will not be communicated to any party other than to the principal owners of the Seller, who you will ensure are made aware of the terms of this paragraph and who will be similarly obliged to maintain confidentiality. The Buyer and Seller have entered into a Confidentiality Agreement dated as of May 8, 2013, the terms, covenants and conditions of which will remain in place during the entire process. The Buyer, Seller and any affiliates of each remain subject to the Confidentiality Agreement. 11. Effect of this Proposal Except with respect to the obligations set forth in paragraphs 7, 9, 10 and 11 of this Proposal, this Proposal is not intended to be a binding contract. The parties shall not be legally obligated by any of the terms hereof, other than paragraphs 7, 9, 10 and 11 hereof, unless and until the terms of this Proposal are embodied in a definitive purchase agreement in form and substance satisfactory to the parties, and executed and delivered by them. We at the Buyer are excited about the opportunity to consummate a transaction with the Seller and to work closely with the management team to develop a local presence in the Mid Atlantic and Southeastern US market. We would be pleased to provide any clarification, which you may require regarding this letter. We reiterate our belief that a combination of the Buyer and Seller would be in the best interests of the shareholders, management and employees of both entities and could be completed in an expeditious manner. 19

Should you have any questions or need further clarification with regards to our proposal, please contact me at (123) 456 7890 or if you are in agreement with the forgoing, please indicate your approval by signing and returning a copy of this letter to me on or before August 31, 2013 and we will begin the due diligence process and prepare the Purchase Agreement and other necessary documentation. Sincerely, President Buying Company The foregoing is accepted and agreed to this 18 th day of August, 2013. for Seller 20

Working Capital Management, LLC Balance Sheets December 31, 2012, June 30, 2013 and September 30, 2013 Assets 30-Sep-13 30-Jun-13 31-Dec-12 Current Assets Cash - 2,597 - Accounts Receivable 878,863 811,452 779,066 Inventory 681,476 778,006 813,168 Prepaid Expenses 12,748 24,768 26,385 Total Current Assets 1,573,087 1,616,823 1,618,619 Property, Plant and Equipment Leasehold Improvements 15,257 15,257 15,257 Vehicles 122,791 122,791 182,375 Office Equipment 223,035 223,035 203,946 361,083 361,083 401,578 Less Accumulated Depreciation (241,922) (220,447) (273,709) Net Property, Plant and Equipment 119,161 140,636 127,869 Total Assets 1,692,248 1,757,459 1,746,488 Liabilities and Owners' Equity Current Liabilities Accounts Payable 429,358 434,551 364,137 Line of Credit 474,668 398,194 311,576 Other Payables 120,308 164,033 124,198 Current Maturities of LTD 21,379 20,669 20,500 Total Current Liabilities 1,045,713 1,017,447 820,411 Long-term Debt, net 45,196 50,935 73,402 Owners' Equity Capital Stock 5,000 5,000 5,000 Retained Earnings 899,318 915,705 847,675 Owner Distributions (302,979) (231,628) Total Owners' Equity 601,339 689,077 852,675 Total Liabilities and Owners' Equity 1,692,248 1,757,459 1,746,488 21

Working Capital Management, LLC Working Capital Management in a Merger or Acquisition Transaction You were given a signed Letter of Intent recently signed by a client of yours (he did not consult you before he signed the letter). He is asking that you help him through the rest of the transaction. The last financial statements given to the Buyer prior to receiving the Letter of Intent were December 31, 2012. 1. What major red flag do you see in the Letter of Intent? Who is it an opportunity for? 2. Review the attached Balance Sheets of the Seller for December 31, 2012, June 30, 2013 and September 30, 2013. 3. In retrospect and knowing that the type of offer made was coming based on information given to the Buyer in June, what would you have done differently as the Seller prior to the September 30, 2013 closing? 4. In retrospect what would you have done differently as the Buyer? 5. If closing had already occurred on September 30, 2013 and you are asked to evaluate the transaction, what would you say to the Seller? 6. If closing had already occurred on September 30, 2013 and you are asked to evaluate the transaction, what would you say to the Buyer? 7. What are the differences between a Targeted Working Capital and a Targeted Equity Requirement for a Seller? 8. What are the differences between a Targeted Working Capital and a Targeted Equity Requirement for a Buyer? 9. What are the issues involving the Section 338(h)(10) Election? (Item #8 in the Letter of Intent) 22

Working Capital Management, LLC Working Capital Management and Inventory Control Inventory Control in a manufacturing operation can be difficult and can often determine whether a company is profitable or not. If the company must also store the finished goods for an extended period of time, additional concerns arise. Therefore proper control over inventory in most manufacturing companies is likely the key element in working capital management. Let s work through an example that will demonstrate the need for controls. Take a food canning operation. Raw Materials (RM) 1. Empty cans (Different sizes along with cylinders and ends) 2. Produce 3. Brine 4. Labels 5. Boxes 6. Trays Temporary Finished Goods (or almost finished goods) Brites Finished Goods (FG) All 6 RM must be separately traced through the system and accounted for Empty Cans are the easiest to trace because the accounting is one for one (or two for one in the case of ends ) and the cost and size of the RM is large enough that the item is reasonably controllable. Control begins at the time the order is placed. First the price must be established so that when the RM is received the expected price can be traced to the invoice. So a price variance at the RM warehouse level must be established. I recommend that the RMs are transferred in the manufacturing costing system at a standard cost and purchase price variance controlled at the RM level. Changes in the standard price can be controlled and later in the process the price variances can be costed in the price of the FG. Quantity Control is the responsibility of the RM warehouse manager. The person needs to control what he has in the warehouse, what he receives (both from suppliers and from manufacturing department), what he issues to the manufacturing department and the damage, shrinkage and other shortages at the warehouse level. Damages, et al in the manufacturing department are accounted for separately. For each period or for any 23

Working Capital Management, LLC period requested by management, the warehouse manager must account for the beginning quantities plus receipts less issued quantities less documented shortage that will equal not only the amount in the records as the ending inventory, but also must be reconciled with a physical count that agrees with the recorded ending inventory. Within the manufacturing department there is a separate level of accountability for each major process. Empty cans and ends are placed into the process at the beginning of the manufacturing line. The group is responsible for reporting the number of cans placed into production and therefore is accountable for any cans that do not make it to the cooker. The same is true for the cooking group. What went into the cooker should come out and proper control and accountability established. Mechanical counters can be established to account for the cans that go into the cooker and the number that come out. But it is incumbent on each section of the manufacturing operation to know the number of cans it received and compare with the counters record that left its section. Any difference should be accounted for in damage et al and documentation prepared for these losses and for quantities that are returned to the RM warehouse. The Brites warehouse then receives the almost finished product and is responsible for what comes into its department and should account for the items it receives in a similar manner as the RM warehouse controls. However greater care is required as the product is now much more subject to theft and damage even the type not caused by the warehouse personnel or other carelessness. If warehousing the inventory is not properly managed, damage caused during cooking can be exacerbated by not examining and checking on the condition of the stored products to insure damaged product does not cause damage to other products (products are stored together and leakage from a can may drain on other products resulting in damage to an otherwise good product). Once the product is ready to be labeled and packaged for delivery, it once again leaves the warehouse and goes to another manufacturing department. The same accountability used in the first phase of the manufacturing process is required the department receiving the product must account for how much it receives and how much is returned to the warehouse once it is labeled and packaged and document any shortages. When the FG is ready to be shipped, once again the product is transferred out of the warehouse and this time shipped to the customer. The Brites and FG warehouse managers have the same accountability that the RM warehouse manager has (discussed above) once again tying to a end of period physical count. The accountability at each level becomes increasingly important as the product increases in value at each stage of the process and is more susceptible to loss through damage, obsolescence or theft. 24

Working Capital Management, LLC One final accountability level is required. The number of empty cans that were received should reconcile back to the number of cans that were shipped to customers. For this to have any meaning, each department through which the can travels must account for and report its results as described above. One person must be able to follow the flow of the can though the system and reconcile the results reported by each group. The process is similar for the other RM. With Brine an additional concerns arises as the amount of Brine that goes into each can is not on a one to one basis and measurement of and controls must be established for the amount used as compared to the production standard. If the amounts are properly measured, the results should be reconciled without variance (subject to reported mistakes and other documented shortages). Produce is not so easily measured. Purchase price variances must be made in light of subsequent price adjustments for the quality of the produce received. The quantity per can and the volume produced from each pound purchased is more subjective and the quality of the produce can have a material effect on the yields and production results. The pounds placed in each can is not exact and therefore must be considered in the yield factors. Averages are established and poor yields must be accounted for so that proper charge backs can be issued to the supplier. Labels, Boxes and Trays are similar to cans. Labels are one for one, but once put in a Box or a Tray, the unit of measure changes from cans to cases and a new accountability is set and proper conversions made to insure reconciliations can be accomplished. If FG are properly managed, the product will last for a long time. But unless a proper system is established to insure the flow of product is followed, the inventory can be spoiled and expiration for the use of the product can occur. Other significant controls are required in the manufacturing process to insure food standards are met, but they are not part of the Working Capital Management and therefore not part of this discussion 25