Canada: The Hidden Value on Your Balance Sheet

Last Updated: September 17 2015
Practice Guide by Duff & Phelps

Business owners and executives place considerable emphasis on the amount of profit generated by their company. In many cases, the assets and liabilities required to support their company’s income generating capabilities are taken for granted. However, in many cases, the balance sheet holds hidden opportunities for increasing shareholder value. This is particularly the case for net working capital.

Net working capital is defined as the difference between a business’ current assets and current liabilities. Therefore, working capital management requires consideration of both specific current assets and current liabilities, as well as a holistic approach of the relative levels. This article begins with a discussion of why working capital management is important and then highlights a few areas where value enhancement opportunities are frequently found.

The Importance of Managing Working Capital

A company’s net working capital represents an investment by its shareholders. The lower the amount of investment for a given a level of cash flow generated by a company, the better the shareholder’s returns. For example, if a company generates discretionary (after-tax) cash flow of $1 million per year on $10 million of invested equity, it represents a return on equity of 10%. However, if that same $1 million of discretionary cash flow can be generated on an equity investment of $7 million, the return on equity increases to 14.3%.

Notably, working capital levels within a business represent after-tax dollars invested in a company. Therefore, a $1 reduction in a company’s net working capital is worth more to its shareholders than earning an extra $1 of operating (pre-tax) income from higher revenues or cost reductions.

Furthermore, a company’s working capital requirements will serve to strain its cash flows during periods of growth. This is because, as a company grows its revenue base, working capital levels usually grow by a proportionate amount.

By way of example, assume that Company X, which currently generates $50 million per year in revenues and requires net working capital of $6 million, is initiating an expansion plan with the following characteristics:

  • the plan will increase its revenues by 20% (i.e. $10 million);
  • Company X expects to generate a pre-tax profit margin of 15% on that incremental revenue; and
  • Company X pays income tax rate at a rate of 35%.

Assuming that net working capital increases proportionately with revenues, it results in the following cash flow consequences:

As evidenced in the above example, despite the ability of Company X to generate incremental revenue and net income from its expansion program, its cash flow has initially decreased. Although this shortfall will not recur once growth has stabilized, the initial deficit will have to be financed (either through a bank loan or equity capital injection) or alternatively, may impair the ability of Company X to achieve its growth plans.

Obviously, there is a limit to how far net working capital levels can be reduced before a company finds itself operating at levels that cause it undue risk. It is prudent to allow for some cushion, in the event that the company faces short-term turbulence in its operations.

Managing Current Assets

Cash on Hand

Many companies generate cash from their operations and leave the extra funds within the business. However, retaining “redundant” cash within a company (i.e. permanently excess cash, as opposed to a seasonal surplus) often contributes to poor working capital management practices. This is because business owners and executives become accustomed to drawing on the excess cash when needed, and hence they are less vigorous in managing other working capital accounts.

This situation can be prevented where excess cash is paid to a holding company as a tax-deferred dividend. Business owners and executives then become more conscious of having to draw on that excess cash, because it requires a formal loan or equity investment from the holding company back into the operating company. This can be a good warning sign that working capital management is slipping.

Accounts Receivable

Many companies operate with an average collection period for their accounts receivable that is well beyond their stated payment terms. This is often the case because business owners and executives are concerned that aggressive collection efforts will erode customer goodwill. However, in most cases, customers are more concerned with issues such as product quality, service levels and on-time delivery. If a company is relying on extended credit terms as a primary differential advantage, it has bigger problems than just accounts receivable management. In our experience, once customers become accustomed to being politely reminded of past due accounts, they are more inclined to form a habit of timely payment.

Another reason for overdue accounts receivable is a company’s billing practices. Many companies send out invoices long after their products and services are provided to customers. The faster that an invoice is processed the quicker it will be paid.

Inventories

In many cases, companies carry excess inventories to ensure that they can meet customer demands on a timely basis. While product availability can be an important operating initiative, it often extends to a point where companies feel the need to overstock. Higher inventories can also result in higher incidental charges for storage and the risk of obsolescence.

When assessing the risk of lost revenue against the cost of inventory management, business owners and executives should consider the profit margin that is generated on revenues. It is the potential loss in net profit, not the potential loss in revenue, which should be weighed against the cost of maintaining additional inventory.

Prepaid Expenses and Deposits

Many companies have a considerable amount of cash tied up in prepaid expenses and deposits. In some cases, these balances have been carried for many years. It is worthwhile to periodically review these prepayments to determine whether any of them can be recovered, especially where the company has established a firm relationship with that supplier and has the financial strength and credibility such that a prepayment or deposit is no longer required.

Managing Current Liabilities

Bank Loans

Bank operating loans and other debt facilities were addressed in the Summer 2008 edition of Value Strategies. Essentially, business owners and executives can magnify shareholder returns by using an appropriate amount of debt within their company, rather than relying entirely on equity capital.

Accounts Payable

Companies should stretch their accounts payable to the extent possible, without aggravating their suppliers. That being said, discounts for early payment often are more lucrative than they may appear. For example, payment terms of “1% 10 days net 30 days” effectively offers a 1% discount for paying 20 days early. This translates into an effective annual interest rate in excess of 18%.

Where a company has suppliers that may be facing cash flow difficulties (e.g. due to the current economic environment), it should approach those suppliers with a proposal for early payment discounts. The supplier may place a premium on early collection in order to satisfy its banking covenants.

Deferred Revenues

Where possible, companies should pre-invoice for the products and services that they provide. This can have a dramatic positive impact on reducing working capital levels. It may even be worthwhile to offer customers a discount or some other benefit for advance payments.

A Holistic Approach to Working Capital Management

While each individual working capital account should be considered, business owners and executives must take a holistic view to working capital management. This is because working capital accounts often are intertwined (e.g. inventories are tied to accounts payable) and because of working capital covenants imposed by lending institutions (in the form of minimum working capital levels or ratios).

While the absolute amount of net working capital is important to consider, a company should also keep track of its “net trade working capital” ratio. Net trade working capital examines the non-cash components of working capital that vary in conjunction with revenues. The net trade working capital ratio usually is calculated as follows:

 

[ACCOUNTS RECEIVABLE] + [INVENTORIES] – [ACCOUNTS PAYABLE] – [DEFERRED REVENUES]


TOTAL REVENUES

 

The net trade working capital ratio helps business owners and executives to relate working capital requirements to the operating levels of their company. This helps in planning for financing requirements to support a company’s growth initiatives and, when compared to other companies within the industry, serves as a benchmark for assessing management performance and working capital efficiency.

In summary, the income-producing capability of a company must be related back to the underlying assets and liabilities required to generate those results. By implementing strong working capital management practices, business owners and executives can significantly increase shareholder value.

This document is not intended to create an attorney-client relationship. You should not act or rely on any information in this document without first seeking legal advice. This material is intended for general information purposes only and does not constitute legal advice. If you have any specific questions on any legal matter, you should consult a professional legal services provider.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Contact the Author?
Click here to email the Author
In Association with
In Partnership with
Other Canada Advice Centres
Competition and Antitrust
Mergers and Acquisitions
Labour and Employment
More Advice Centers
Useful Resources
CBVs are experts in their field. The following articles and papers have been written by CBVs, several articles have been featured in various national publications.
Tools
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.