In a widely reported incident, a public company’s executive officers accelerated receivables and delayed vendor payments, so they could shift cash into their fourth quarter to meet year-end “free cash flow” targets. Those targets were communicated publicly, and determined the executives’ annual stock and bonus awards. A whistleblower reported the malfeasance, the corporate officers were suspended, and the stock immediately dropped by 42%.
If you own a private company, you can accelerate receivables with spiffs and discounts. You can delay vendor payments, too. Obviously, these are considered bad practices, even though they may create a “sugar high” in increased cash proceeds. But, as with sugar highs, the benefits are temporary.
On the other hand, if you are a private company in the midst of being acquired, or seeking acquisition, accelerating receivables or delaying vendor payment is a really bad idea.
Here’s why: Every acquisition has a Net Working Capital “PEG”—a target dollar amount—established at close. The NWC PEG is essentially current assets (inventory, AR, etc.) minus current liabilities (accounts payable, etc.). The NWC is commonly used to gauge the short-term health and liquidity of a business. It also historically tracks what levels of current assets and liabilities are required to operate.
Since our industry is seasonal, the NWC figure used when a company is acquired is calculated at close on a TTM (trailing twelve month) basis. The TTM perspective averages out the high inventory levels you bulked up on, say, at a buying show, while accounting for low inventories when you sell down in busy months.
During an acquisition, the NWC is calculated right up until the day of the closing. At the close, if you, the seller, are under the twelve-month average–maybe you sold down roof shingles because of a recent hailstorm–you owe the acquirer the difference between the TTM NWC and the NWC “PEG” at closing. That’s because the reduced shingle inventory (exaggerated by a burst of activity) dragged the inventory value down below the TTM average. Sure, the sale of the shingles added to your earnings, but you have to account for the replacement cost of the shingles the acquirer will spend to bring levels back to the TTM average.
On the other hand, if you, the seller, are over the TTM NWC vs the NWC PEG–maybe because you bulked up just before the closing on shingles for thunderstorm season–then the acquirer owes you the difference. The reason: the acquirer is getting inventory above the TTM average. Those are extra shingles you paid for, and you are not obligated to give to the acquirer without compensation.
You can now see that spiffing receivables to goose the cash line on your balance sheet is unfair to the acquirer, because you artificially reduced receivables by moving receivables to cash on your balance sheet; that’s cash that you keep in a cash-free/debt-free deal.
At an acquisition’s closing, since the NWC is dynamic and changes by the day, both the seller and acquirer agree that the NWC figure used at close is provisional, since it might not contain every last item, (e.g. tax refunds, sales tax accruals, insurance prepaids). So, almost all acquisitions have a “true-up” that takes place around 90 days after the closing. The true-up looks back to the at-close NWC, and—with all the at-close credits and debits flushed through the system—makes sure the NWC figure was indeed correct. If it were under the TTM average used at close, the seller would owe the acquirer some money. If the NWC were over the at-close TTM NWC average, the acquirer pays the seller that difference. You can now see why the NWC and NWC PEG are so central to making sure the obligations of the seller and acquirer are both treated fairly and equitably.
