Leveraging existing working capital for new investments is a special circumstance indeed – but also one that can prove extremely valuable if conditions permit.
So what does leveraging working capital mean anyway? It simply means borrowing against A/R and inventory balances – which although they are individually generally short lived assets – are constantly replenished as businesses operate and therefore create a financing need in most business models.
In most instances, a company’s working capital is financed by a combination of debt and equity. Some companies, however, do not have much, if any, debt. And if this situation exists contemporaneously with an attractive investment opportunity, leveraging working capital can be a quite attractive option. The stars fitting this description don’t align all that frequently in practice, but when it does here is how it works.
The company simply borrows against its working capital assets – either for the first time or in an amount greater than the debt currently outstanding against those assets. The company then uses a portion of the proceeds (excess proceeds in the case of incremental borrowing) to invest in the new opportunity. All seems straightforward enough up to point right?
The trick is determining what portion, if any, of the excess proceeds can be reasonably directed towards the new investment opportunity – without placing an undue burden on the cash flow profile of the company. The most complete way to make this assessment is by building out a cash flow model and testing the tolerances in various projected scenarios. Given that modeling can be a time consuming and messy process, there are some rules of thumb a company can use to determine if it will work – and if so, in what magnitude. Some of those rules of thumb are as follows:
1. The higher the operating margin on the product or service – the more likely excess working capital will be available. To determine roughly how much, the following formula is a decent proxy – the sum of 80% of A/R + 50% of inventory (at cost) multiplied by your operating margin. So if you have A/R of $100 and Inventory of $100 and your operating margin is 20% – you can estimate that you have ~$26 in excess working capital to invest.
2. The higher the net worth of the company prior to the investment – the more likely a company will be able to leverage its working capital. This rule of thumb essentially permits existing equity to be leveraged more, but is nonetheless a viable proximity tool.
3. The less the existing debt on the company – the more likely excess working capital will be available. This one is simple enough as you will only have “excess” availability based on nature of your assets – and those are already partially levered, then additional “excess’ will be lesser.
As we mentioned above, this circumstance does not present itself in practice all that frequently, but when it does it can be a very nice option. We ran into this situation again just recently – so although somewhat rare – it does happen – so be on the lookout.