Valuing a Seasonal Business to Assess Solvency

The enterprise value of a business is very important to creditors, especially if the business is distressed. Comparing
enterprise value to the amount of debt determines whether a creditor has an equity cushion or is underwater. An
appropriate assessment of enterprise value can help to accurately assess the debt capacity of a business. Thus, an
enterprise value analysis is part of the foundation behind any restructuring. An understatement of value can result in
creditors taking an inappropriately large haircut. Or, it may result in an incorrect conclusion to liquidate a business.
On the other hand, an overstated value can result in over-leveraging a business, resulting in post-restructuring
financial distress and reduced recoveries.

Accounting for working capital when valuing a business can present a unique set of challenges. Changes in working
capital can have a material impact on enterprise value. Sometimes, working capital changes (and the associated
cash-flow changes) are permanent in nature; such changes often result when a business grows. This business requires
more inventory and generates greater accounts receivable. Growth results in permanent increases in inventory and
accounts receivable, which can be used to secure borrowings. As long as a business does not shrink, changes in
working capital resulting from growth can usually be financed permanently with accounts payable and revolving
credit lines. When projecting cash flows for a growing business, an important consideration is the cash-flow impact
of permanent changes in working capital that result from growth.

On the other hand, sometimes working capital changes are more temporary in nature, resulting in a cash-flow
impact that will later be reversed. This is common with seasonal businesses that often experience the following
cycle:

1. Just before a peak season, the company will build its inventory and will finance the purchase with
   borrowings secured by inventory and accounts receivable (usually in the form of a revolving line of credit).
2. During and just after the peak season, when the combination of inventory and accounts receivable is at its
   seasonal peak, the revolver balance is also at its peak.
3. As the inventory is sold and the accounts receivable are collected, the cash is used to pay off the revolver.
   Inventory, accounts receivable and the revolver all reach their troughs before the firm prepares to enters into its
   next peak season (returning then to the beginning of this cycle).

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[W]hen valuing a seasonal business using an annual DCF, it is of great importance to understand where the business is in its annual cycle. The timing of the valuation date within the firm's yearly cycle is critical to a correct valuation and assessment of solvency.

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Correctly identifying working-capital changes by type (permanent vs. temporary) is the first step toward correctly
accounting for working capital. Seasonal businesses that are growing will have both types. Accounting for
permanent changes in working capital when valuing a business is generally simpler than accounting for temporary
changes. Additionally, it is particularly important to creditors of a distressed company to understand the impact of
temporary working-capital fluctuations in determining whether the firm is above or below water.

The most common way to calculate enterprise value is to discount projected unlevered cash flows to their present
value—i.e., to perform a discounted cash flow analysis (DCF). Similarly, the most common way to value the
equity of a business is to subtract total debt from the concluded enterprise value. Changes in working capital must
be properly projected and considered when developing a DCF. To do so can be complicated for businesses that
experience fluctuations in working capital, such as firms in seasonal industries like retail, distribution, construction
and some manufacturing.

Using a DCF to calculate enterprise value involves projecting operating and investing cash flows, including
projected changes in working capital. If a DCF is prepared on an annual basis (as most DCFs are), seasonal changes
in working capital will not be reflected in the projected cash flows as they will reverse during the same projected
year—even though the seasonal changes will occur within a forecasted year. For example, during an off season,
inventory, accounts receivable, accounts payable and the revolving debt balance will be at relatively low levels.
During a peak season, inventory, accounts receivable, accounts payable and the revolving debt balance will be at
relatively high levels. Since these seasonal balance-sheet account changes are not reflected in the cash flows of an
annual DCF, the amount of excess seasonal working capital at the valuation date, if any, must be calculated and
added to the results obtained from the discounting annual cash flows. This is particularly important when assessing
the solvency of a business.

Consider a business that is not growing. At any valuation date, the annual cash flows generated by the business are
the same. Therefore, without any adjustments, a DCF would result in the same enterprise value conclusion for this
business regardless of the valuation date. However, the revolving debt balance for seasonal businesses can vary
substantially within any given year, as it is used to finance the build-up of inventory and accounts receivable during
peak seasons. If no adjustments are made to the value conclusions using a DCF, the concluded equity value of a
seasonal business will incorrectly be lowest during its peak season, when revolving debt balances are highest, and
highest during its slow season, when revolving debt balances are lowest. By simply observing the stock prices of
publicly traded retailers and other seasonal businesses, it is obvious that equity values do not consistently decline
during peak periods (e.g., the holidays) and increase during slower periods. Adjusting for seasonal swings in
working capital will result in a correct calculation of enterprise and equity values.

Valuing Swings in Working Capital

Since the total debt and total assets of a seasonal business swing substantially in a typical year, these swings must
be carefully analyzed and understood. To arrive at the right enterprise value and equity conclusions, the trough level
for required working capital and for the line-of-credit balances must be determined. In a given firm, these items
usually reach their trough levels just before this business begins building up its inventory for a peak period. The
operating working capital and financing at this point in time can be considered the "permanent" portion of working
capital and the "permanent" level of revolving debt.

A sample calculation of the permanent portion of a company's working capital, or the lowest level of required
working capital within one operating cycle, is presented in Table 1 ($30 million). It is at this point in the operating
cycle that the revolving debt is also at its trough, representing the permanent amount of revolving debt ($10
million). If a company is valued as of its trough period, no adjustments for excess working capital are necessary
because the working-capital balance and the related revolving-debt balance are at permanent levels. Simply
subtracting total debt from the enterprise value derived from projected cash flows results in a correct equity value
conclusion (see Example 1 in Table 1).

However, if the valuation date is as of any other period, the excess working capital at that date—i.e., the
working-capital balance (excluding revolving debt from the calculation) in excess of the trough level—must be
added to the conclusion using an annual DCF to arrive at the appropriate enterprise value conclusion. From this
sum, total debt should be deducted to calculate equity value. Excess working capital is often offset, at least
partially, by an increase in the revolver balance. As a result, though a company's assets may increase as inventory is
purchased and additional accounts receivable are generated, its liabilities also increase (as the revolver increases), and
thus its equity value changes by very little (see Example 2 in Table 1). As illustrated in the example in Table 1,
which assumes that all changes in working capital are financed with the revolver balance, equity value does not
change each quarter, even though assets increase because the revolver balance also grows. This example shows the
importance of making balance-sheet adjustments when determining the enterprise value of an entity for the purposes
of evaluating a company's solvency position.

It is important to consider excess cash a company may use to finance some of its working-capital requirements
instead of using revolving debt. Excess cash must be added to the value concluded using a DCF to correctly
calculate enterprise and equity values. If excess cash exists, it will most likely be highest during trough seasons. In
fact, it is likely that excess cash in peak seasons will only be evidenced by relatively low revolving-debt balances,
and no excess cash will be available during peak seasons.

Much like working capital, if excess cash is accounted for correctly when it exists, equity values will not change
through the seasons. This can be illustrated using the figures in Table 1. If the company had $10 million of excess
cash at the trough, its enterprise and equity values would have been $10 million higher, or $110 million and $80
million, respectively. If the business used this excess cash during the next several months to finance some of its
purchases of inventory, the company would have required $10 million less in borrowings. As a result, the enterprise
value conclusion at the peak would have remained at $170 million, but the equity value would have been $10
million higher at $80 million because the revolver would have been lower by $10 million.

In summary, when valuing a seasonal business using an annual DCF, it is important to understand where the
business is in its annual cycle. The timing of the valuation date within the firm's yearly cycle is critical to a correct
valuation and assessment of solvency. The minimum amount of required working capital for a business must be
determined, and any working capital above this amount should be considered excess and added to results obtained
from the DCF. It is then appropriate to compare the enterprise-value conclusion to the total debt of the entity to
evaluate its equity value and solvency.

Conclusion

Businesses often experience both types of working-capital changes: permanent, resulting from growth, and
temporary, resulting from seasonality. Permanent working-capital changes should not be considered excess. The
permanent portion must be separated from the temporary portion, and only the latter should be considered excess
when calculating enterprise value. Finally, all of these valuation analyses may be irrelevant if a business does not
continue as a going-concern. Inventory and accounts-receivable values in a liquidation are almost always below their
going-concern values. When a company elects to liquidate, the relationship between the revolver and the value of a
company's assets is usually dramatically altered; the methodologies described here to assess equity value or
solvency would most likely not apply.

Footnotes

¹ Gary Durham is a senior associate with AlixPartners based in Dallas, where he assists companies in situations involving restructuring, recapitalizing, solvency analysis, business planning, valuation analysis, damage calculations and various litigation issues. He can be reached at 2100 McKinney Avenue, Suite 800, Dallas, TX 75201, (214) 647-7500, fax
(214) 647-7501. Return to article