The Daily Technical #139: Why are cash and debt excluded in the calculation of net working capital (NWC)?

Good evening. Welcome to the 139th edition of The Daily Technical.

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OVERVIEW OF YESTERDAY’S QUESTION
What levers have a positive/negative impact on the IRR of an investment?

Positive IRR Levers:

• Earlier Extraction of Proceeds: Can be achieved through a dividend recapitalization, an earlier-than-expected sale, the receipt of cash interest (as opposed to PIK interest, for debt investors), and annual monitoring fees paid to the sponsor

• Increased FCFs: Results from strong revenue generation, EBITDA growth, and an improved margin profile all result in more debt being paid down throughout the holding period

• Multiple Expansion: Entails exiting at a higher multiple than the entry multiple

Negative IRR Levers:

• Delayed Receipt of Proceeds: Often caused by a sale pushed back to a later date due to lack of buyer interest or unfavorable market conditions, receipt of PIK interest (for debt investors)

• Decreased FCFs: Caused by falling short of initial forecasts or decreased profit margins from external factors (e.g., higher unit costs). The result is less debt being paid down in total

• Multiple Contraction: Investment is exited at a lower multiple than the purchase multiple

Common Mistakes

1. Ignoring the importance of timing when discussing IRR. Earlier cash flow extraction boosts IRR, but be specific about methods like dividend recapitalization. Always consider how aligning cash flows with investment horizons influences returns.

2. Underestimating PIK Interest Impact. PIK interest can substantially delay expected proceeds. Students may underappreciate its negative effect on IRR compared to cash interest. Emphasize the importance of receiving cash interest to improve investment returns.

3. Focusing solely on one lever without considering others. IRR drivers often interact, influencing each other in complex ways. Always evaluate how multiple factors collectively impact IRR to provide a comprehensive assessment.

TL;DR

• Positive Levers: Extract proceeds earlier (e.g., early sale, cash interest, dividend recapitalization); increase FCFs via revenue/EBITDA growth; exit at a higher multiple.

• Negative Levers: Delayed proceeds from postponed sales or PIK interest; decreased FCFs from forecast misses or margin decline; exit at a lower multiple.

• Tactics: Focus on timing transactions and revenue growth to enhance IRR; recognize external factors affecting proceeds and cash flows.

• Goal: Use strategic financial decisions to improve IRR by managing cash flow timing and transaction multiples effectively.

TODAY’S QUESTION
Why are cash and debt excluded in the calculation of net working capital (NWC)?

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THAT’S A WRAP
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