Why buyers care about cash more than profit
How profit and cash come apart, what working capital does to the money you receive at completion, and why growth is so often the thing that empties the bank account.
You know the business is profitable. A buyer wants to know something else, which is how much of that profit ever becomes money. Profit is an opinion. Cash is a fact. Every experienced buyer has heard that line, and most of them believe it, because they have each bought at least one profitable business that could not pay its suppliers.
A business can be profitable and run out of money. It happens most often when the business is growing, because growth consumes cash long before it produces any.
This page covers three things. Why cash and profit differ. What working capital does to the amount you actually receive at completion, which is the most expensive thing most owners have never heard of. And how quickly your business turns profit into money, which is what a buyer is really pricing.
Where the profit goes
The gap between profit and cash is not mysterious. It is a short list of specific things, and you can work through it for your own business in about twenty minutes.
A business turning over €4,000,000 and growing steadily.
€500,000 of EBITDA, €30,000 of cash| EBITDA | €500,000 | |
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| Increase in debtors | -€180,000 | You invoiced more, so more of your money is sitting with customers who have not paid yet. |
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| Increase in stock | -€90,000 | More sales require more on the shelf. |
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| Increase in creditors | €60,000 | You also owe your suppliers more, which is a source of cash rather than a use of it. |
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| Capital expenditure | -€140,000 | Two vehicles and a machine. EBITDA ignored this entirely. |
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| Interest | -€35,000 | |
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| Tax | -€85,000 | |
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| Cash actually generated | €30,000 | |
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Nothing here is wrong or unusual. This is a healthy, growing, profitable business. It simply produced €30,000 of spendable money out of €500,000 of profit, and a buyer will price the €30,000 rather than the €500,000 when they think about what they can take out.
Growth is the most common reason to run out of money
This is counterintuitive enough that it catches experienced owners. When you grow, you pay for the materials, the wages and the delivery before your customer pays you. The faster you grow, the wider that gap becomes, and the gap is funded out of your bank account.
Revenue rising from €4,000,000 to €5,200,000, on a cost of sales of 60 percent, so €2,400,000 rising to €3,120,000. Debtors at 60 days of revenue, stock at 45 days of cost of sales, creditors at 40 days of cost of sales.
What growing thirty percent costs in cash| Money tied up in debtors, before | €657,534 | |
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| Money tied up in debtors, after | €854,795 | |
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| Extra cash absorbed by debtors | -€197,261 | |
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| Extra cash absorbed by stock | -€88,768 | |
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| Extra cash released by creditors | €78,904 | You owe suppliers more, which helps. |
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| Cash consumed by growth | -€207,125 | |
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Each balance above is rounded to the nearest euro and the movement is then taken between the two rounded balances, which is how a set of accounts would show it. Working from the change in revenue directly gives figures a euro either side of these. The business is more profitable than it was, and it has €207,125 less in the bank. If it also needed new equipment to handle the volume, the position is worse again.
The practical consequence for a sale is that fast growth in the year before you go to market can look impressive on the profit line and alarming on the bank statement. Be ready to explain it, with the arithmetic above, before a buyer forms their own theory about why your cash balance fell.
The working capital peg, and what it quietly costs you
Almost every sale contract requires you to leave a normal level of working capital in the business. It is called a working capital target, or a peg.
The reason it exists is straightforward. If you knew you were completing on the thirtieth of June, you could stop paying suppliers in May, chase every customer hard, and run the stock down to nothing. You would extract an extra few hundred thousand euros of cash and hand the buyer a business that has to spend the same amount in July just to get back to normal. The peg prevents that.
Here is the part that costs owners money. The peg is normally set as an average of the twelve months before completion. Which means the working capital you carry during the year before you sell is the working capital you will be required to leave behind.
What to do about it, starting a year out
- Measure your debtor days now, monthly, and write the number down. You cannot manage a drift you are not watching.
- Collect properly and consistently. Not a push in the final quarter, which shows up as an obvious anomaly and gets excluded from the average anyway.
- Clear obsolete stock before the year the average is measured over, not during it.
- Do not stretch your suppliers to flatter the figure. Buyers check payment terms against the ledger, and a supplier base that has been squeezed is a risk they will price.
- Ask early how the peg will be defined. Which items are in it, and over what period. This is negotiable, and it is negotiated far more easily before you have agreed a headline price than after.
Cash conversion, and what it does to your multiple
Cash conversion is the share of your EBITDA that becomes real money after the working capital movement and the capital expenditure needed to stay where you are.
Two businesses, identical EBITDA | Business A | Business B |
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| EBITDA | €500,000 | €500,000 |
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| Capital expenditure to stand still | -€60,000 | -€190,000 |
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| Working capital movement | -€40,000 | -€110,000 |
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| Cash produced | €400,000 | €200,000 |
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| Cash conversion | 80 percent | 40 percent |
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These two businesses will not be offered the same multiple, and the reason is not sentiment. A buyer funding part of the purchase with debt has to service that debt out of cash, not out of EBITDA. Business B produces half as much of the thing the lender is repaid from, so either the buyer borrows less and bids less, or the bank refuses.
This is the mechanism behind a fact owners often find unfair. An asset heavy business with excellent profits gets a lower multiple than an asset light one with the same profits. It is not a judgement about the quality of your company. It is arithmetic about what can be taken out of it.
What is worth fixing, and when
Cash improvements are unusually valuable before a sale because they work twice. They increase the money in your account today, and they improve the metric a buyer prices tomorrow. Very little else does both.
In rough order of return on effort
- Invoice on the day the work is done rather than at month end. This is free and typically worth two weeks of revenue.
- Agree payment terms explicitly with your largest customers, in writing, and enforce them. Concentration is already costing you on the multiple. Do not let it cost you on cash as well.
- Take deposits or stage payments where your industry allows it. Customers rarely object as much as owners expect.
- Review stock lines that have not moved in a year. They are not assets, they are cash you have already spent.
- Separate the capital expenditure needed to stand still from the capital expenditure that funds growth, and be able to show the split. Buyers will assume the worst if you cannot.
See what your cash position does to the number
Cash conversion, working capital and capital intensity all feed into the valuation, and they are the reason two businesses with the same profit come back with different ranges.
The valuation is free and takes about ten minutes. It will show you where your own cash profile is helping and where it is holding the figure down.
Step one of three: see your number, free, with no account and no name.
See what it's worth