On a cash-free and debt-free basis, most M&A acquisitions are negotiated. At the moment of the sale of a business, the seller retains all cash and pays off all debt.
Does debt free cash free include working capital?
Despite the fact that the parties have agreed on a price, the price can be misleading if the buyer and seller interpret ‘cash free, debt free’ to imply different things. There can be a lot of misinterpretation of this term, which can lead to a lot of conflict between the buyer and the seller.
First, what does the term “free” actually mean?
Although it’s understandable that the phrase “free” can lead to misunderstandings, it should not be seen as a guarantee that a buyer will get their hands on all of the target company’s debts paid in full and all of its bank accounts empty before the transaction closes.
Because the buyer is purchasing a trading company, they should expect it to have both cash and debt at the time of purchase. This is highly unusual.
As long as the buyer doesn’t anticipate the seller to pay off all of the buyer’s trading debts, the buyer isn’t likely to be concerned.
There is no consideration of the target company’s cash or debt position when calculating the ‘free,’ therefore it refers to a headline figure of £X that has been calculated free of those considerations.
From point 4 below, £X is not a price that sellers will receive.
To arrive at the final purchase price, the target company’s real cash and debt balances will be taken into account.
What about cash flow?
When it comes to a ‘cash free, debt free’ deal, the actual working capital of the target company is taken into account in most circumstances (working capital being the amount that the target company needs to finance the running of the business on a day to day basis).
A seller might theoretically manipulate the target company’s cash balances (for example, by postponing the payment of liabilities that do not meet the definition of debt in the acquisition agreement) in order to raise the sale price if it did not contain an adjustment for working capital.
The net current assets of the target company (excluding any assets/liabilities previously taken into account in the calculations of cash and debt) will most likely be computed as the real working capital, but there may be various changes depending on the deal specifics.
Although the term “cash-free, debt-free” is commonly used, it’s important to remember that the working capital adjustment must also be taken into consideration.
Cash and working capital must be maintained at a minimum level
In order for the target firm to continue operating after the purchase, the buyer will require it to have a certain amount of cash and working capital on hand at the time of the transaction.
It can be frustrating for both parties if there is a large discrepancy in their expectations as to proper minimum levels. As soon as possible, the parties should engage in the dialogue.
4. The amount paid will not be X pounds.
The ‘enterprise value’ is likely to be the headline figure of £X.
Enterprise value (EV) is a buyer’s estimation of a company’s true worth, usually expressed as a multiple of its profits before interest, taxes, depreciation, and amortization (EBITDA).
To begin the price computation, the enterprise value is merely a beginning point. It does not take into account the company’s financing arrangements.
A company’s enterprise value must be changed to reflect the real value of the target company’s balance sheet at completion, because the type of funding (e.g. bank loan must be repaid in the future therefore is a liability rather than cash reserves) has an influence. When you subtract out the enterprise value, you are left with the ‘equity value,’ which is what the sellers get paid.
(Enterprise Value + Cash + Debt Working Capital Over/Under) +
The net effect of the different adjustments will determine whether the equity value is higher or lower than the enterprise value (i.e. whether they end up as an overall positive or negative).
Early on in the process, I often advocate a joint computation of what the equity value would be using the most recent set of management accounts as an example. For both parties, this computation will assist them grasp exactly how the system works and the resultant figure, as well as flush out any areas of disagreement about how particular items are going to be treated. It’s always better to avoid these problems than to deal with them after the fact.
Five. The equity value will not be paid in full at the end of the project
If you’ve read through this far, you know that the price (or “equity value”) is based on the target company’s current cash, debt, and working capital balances.
In order to come to an agreement on these statistics, completion accounts will likely be developed.
If you’d want to know more about completion accounts, I’ll go into more detail in a future piece, but for now, let’s just say that the process can take a long time, and there are often arguments between buyers and sellers over how to handle certain assets and liabilities.
It is common for the buyer to only pay a portion of the total price at the time of completion because of this delay in finalizing the numbers. If you’re negotiating a deal and you’re not sure what proportion of the price should be paid, you’ll have to come up with an agreement that works for both parties (e.g. bargaining power, the extent to which the acquisition is being funded by the target company itself, the level of trust between the parties, previous experiences with completion accounts – amongst a host of other factors).
In order for both parties to get to an agreement, they must be realistic about what each other will accept (i.e. a seller will want to maximise the payment but a buyer will not want to overpay and then have to try to claw back payment).
It’s possible that putting a reasonable estimate of the final balance payment into the joint escrow account will help close this hole. As a result, both the buyer and seller benefit from the peace of mind that comes from knowing that the money are available. Escrow accounts will also be discussed in further detail in a future post.
Some of the most typical misunderstandings that arise when a “cash-free, debt-free” agreement is made are outlined below. There are a slew of other factors to think about, but maybe the information presented here can clear up some common misunderstandings.
How is debt free cash free net working capital calculated?
Cash and debt (the current portion only) can be excluded from the calculation of NWC, whereas accounts receivable, inventory and accounts payable can be included in the calculation.
Net Working Capital Formula
Net working capital can be calculated in a variety of ways, depending on what an analyst choose to include or remove from the total figure.
the difference between current assets and liabilities is known as net working capital (less debt)
All accounts are taken into account when formulating the first formula, whereas formulas 2 and 3 reduce it down further (as it only includes three accounts). CFI has further information.
How does a cash free debt free transaction work?
Cash-free debt-free simply indicates that when an acquirer buys another firm, the deal will be structured so that the buyer does not take any debt or retain any cash from that company’s balance sheet.
- Except for a typically negotiated amount of “operational” cash that is deemed a minimal amount that needs to be transferred over in the transaction to keep the operations of the newly acquired business running smoothly, the seller keeps the cash that is on their balance sheet at time of closing.
- The seller is responsible for paying off the seller’s debts.
How is deferred revenue treated in M&A?
If the target company were to be liquidated, the deferred revenue would be realized. If products or services are given after the closing, buyers prefer to classify delayed revenue as debt, because they see it as a burden for the buyer.
How is FCF calculated?
Use sales revenue to look at how much a company earns from its business and subtract the costs connected with that revenue. The income statement and balance sheet are used as the primary sources of data in this strategy. Sales or revenue on the income statement should be subtracted from all operational costs (or “operating expenditures”), which include items like COGS and selling, general, and administrative charges (SGA). FCF can be calculated by subtracting these costs from sales or revenue (SG&A).
Add the required operating capital investments from the balance sheet, which are also known as the net operating capital investments, to arrive at the final result.
What is the difference between working capital and net working capital?
, and should include items like as inventories, receivables, and cash. Everything that can be sold within a year’s time will be considered current assets.
Debts of the present must be calculated. These will be included in the company’s balance sheet, just like assets. A current liability is a debt or tax obligation that must be paid within the next year. Accounts payable and staff salary are also included in liabilities for this year.
Subtract current liabilities from current assets using the net working capital formula.
What does debt free mean?
Having low to no bad debts and an average amount of good debts is the first step toward becoming debt free. This does not mean that you no longer owe any money on your home (or on your automobile). If you have a reasonable amount of debt and are aware of your debt-to-income ratio, you’re in good shape.
How much is LBO debt?
- In the case of a leveraged buyout, the acquisition of another company is financed almost exclusively with borrowed money.
- After the financial crisis of 2008, leveraged buyouts fell out of favor, but now they’re making a comeback.
- A typical leveraged buyout (LBO) has a debt-to-equity ratio of 90% to 10%.
- Even if the target company’s assets can be used against it, LBOs have gained a reputation for being brutal and predatory.
Is Deferred income working capital?
Every transaction in which deferred revenue is involved is likely to be the subject of controversy. If you’re looking to categorize deferred income as either working capital or debt, there are certain characteristics and industry conventions that can help you make your case.
Sellers want to classify deferred revenue as working capital, but bidders prefer to include deferred revenue as debt on the balance sheet.
According to a bidder’s argument, deferred revenue is a debt since the seller has received cash for services that will be supplied after the project is complete, and a bidder will pay for those services on an equal-to-the-value basis.
It is conceivable that sellers will argue that deferred income is nothing more than a time differential that will only become a problem in the event of a business closing up.
Therefore, it should be considered part of working capital.
A variety of factors must be taken into account while deciding the outcome of the debate, as the positions are so polarized.
- Deferred revenue balances backed by cash or trade receivables are the first things to look into for sellers. It is difficult for a bidder to argue that a payment was made in advance of supplying the service if the money was never received.
- For example, cash receipts in advance of deferred revenues are used to finance the current service’s expenditures if the balance is generally stable during a year’s time. If the balance is shown as a sawtooth pattern, it signifies that the company is in debt, however if it is shown as a smooth curve, it indicates a healthy financial position.
- Due to the fact that there are no more costs to be spent, it would also be impossible to justify deferred revenue as debt.
- In the case of a yearly book, for example, all costs have been incurred, stock has been built up, and orders have been placed, but revenue is held back until the goods have been delivered.
- The nature of the industry can also have an effect on the standard treatment.
- Package holiday operators, for example, may have a large deferred revenue balance since orders are placed and cash is collected well in advance of departure.
- Despite the fact that some of the operator’s expenditures may have been paid in advance, such as block hotel reservations, there may still be substantial costs to be incurred.
- There are several reasons to think of this as working capital, including the fact that it is built up over time and represents a significant financial risk. Bidders will therefore wish to take a price reduction through the use of debt.
If the bidder wants to include the deferred revenue balance as debt, the seller may argue that the balance should be reduced by an amount equal to any costs prepaid in respect of providing the service and the margin to be earned on such orders.
Disputes over deferred revenue are common during a deal, especially if the amount is significant in relation to the total deal value. To put it another way, what I’ve discussed thus far is a fairly simple method.
This and other difficulties that emerge throughout the sale and purchase agreement (SPA) will be discussed at our upcoming seminar on Thursday 25 June at 08:30 in London. To learn more and to sign up, visit this page.
What difficulties have you encountered in dealing with deferred compensation in your business deals? I’d like to know how you got around them and what happened. Share your opinions in the comments section below or set up a private appointment to discuss your problem.
Is Deferred income a debt-like item?
Deferred income must be seen as a form of debt because it has not yet been generated. Unless there is a counter on the asset side (e.g. accumulated income) in which case they can set each other off, it is often a debt-like item.
How does debt affect free cash flow?
Firms must be valued using their free cash flow over a period of time. The company’s financing practices may alter as a result of such a long period of time. Because of this, we need to think about what would happen to the company’s cash flow if financing policies were changed. Analysts typically take into account the reality that a company’s operating costs would fluctuate over time. Inflation, rising costs of raw materials, and pay increases are all taken into account. There is no consideration given to the impact of changes in finance policy. We’ll do the same in this piece.
As a result, the goal is to identify the most likely changes in finance policy. The next step is to determine how each of these policy changes affects the company’s cash flow.
Effect on the Cash Flows:
Leverage has an impact on both cash flow to the firm and the equity of the company, so let’s look at that first.
The change in leverage may be reduced to a single factor, i.e., the change in debt, because we’ve looked at both share repurchases and share buybacks individually.
Free cash flow for the company is unaffected by debt repayment or fresh debt issuance. Due to the fact that firm-wide free cash flow takes into account both stock and debt holders, not just one or the other.
However, when debt is paid off or raised, the free cash flow to equity stockholders is reduced.
Free cash flow to equity is reduced in the current year when greater cash is used to pay off debt immediately. Debt is no longer being serviced, which means that free cash flow to equity will rise in the years to come, counteracting the decrease in free cash flow to debt.
The exact opposite occurs if the company takes on more debt. Free cash flow to equity rises this year, then declines in the following years.
To calculate free cash flow to equity, an analyst must account for the possibility that the company will change its debt policy in the future.
The Case of Increase/Decrease in Dividends, Share Issues and Share Repurchases:
Cases 2, 3, and 4 have been merged into one at this point. The reason for this is that the rationale is the same in all of these circumstances.
Free cash flow to the company and free cash flow to equity are unaffected by changes in dividends, share issuances, and share repurchases! Both EBIDTA and cash flow from operations are used to construct these cash flow metrics.
The net income amount is used to calculate EBIDTA, which occurs before any financing effects on the balance sheet. Regardless of how the money is raised, it will have no impact.
Examiners frequently use this knowledge to confound students. Typically, there will be pertinent information, and then one of the above points will be mentioned. Free cash flow is unaffected by case numbers 2 through 4, so please keep that in mind.
As a result, the only way a company can effect its free cash flows by altering its financing policy is by issuing additional debt!
