You have $25 million that you are going to invest in either Company A or Company B. Which do you choose?
Tell me more, you say.
They both have the same margin structure and sales.
They also have the same:
- growth rate
- products sold through the same channels
- makeup of teams and US location
- cap tables
Hmm. So, what’s the trick?
Let’s add some detail from their balance sheets.
Company B has superior Capital Cycling as evidenced by their much better Inventory Turnover Ratio.
OK. So, it looks like Company is the answer. But why? And why does Capital Cycling matter? A key question we have is ‘what does $25 million get me’? We are not asking about ownership percentage. We are trying to understand what each company will generate in additional sales, profit, cash and valuation from our $25 million investment.
Some simple napkin math provides answers.
A key part of our analysis is knowing how much Net Working Capital each company needs. Again, the companies are incredibly similar with the same Accounts Receivable and Accounts Payable. The only difference being their Inventory. But that difference is massive in their Net Working Capital needs with Company A needing $24 million and Company B needing just $7 million.
In addition to Net Working Capital, we know the other big consumer of cash inside the company is marketing.
We already know the both companies had the same marketing budget of $20 million. So we add that to their respective NWC needs and then calculate the proportions. For example, Company has a combined total of $44.4 million of which Marketing was 45% while Company B’s total is $27.1 million with Marketing being 74%.
In other words, we are asking ourselves, as this company consumes cash, how much of that consumption is Marketing? As investors our goal is to seek valuation increases. The more we can spend on marketing, the more customers we acquire, the more sales we generate…the more we can increase valuation.
Now that we know those proportions, let’s see what each company can do with our $25 million.
The red box just calculates the amount of NWC and Marketing using the proportions we calculated above. We break out Inventory from NWC which we will use below.
In the lower red box, we:
- calculate the additional COGS that our inventory will give us. To do this, we multiply the Inventory by the company’s respective Inventory Turnover Ratio to get the additional COGS. For any given period, The Inventory Turnover Ratio is COGS / Avg Inventory Value. So in here, we know our average Inventory Values are $15.2 million and $8.1 million respectively. So multiplying them by 1.4 and 4.1 respectively gives us COGS of $20.6 million and $32.7 million.
- we can now calculate our Additional Sales. Because the margin structure is the same for both companies we get to $58.8 million for Company A and $93.5 million for Company B.
- we then go through the rest of the Income Statement and because margins are the same, we get to an additional EBITDA of $9.3 million for A and $14.3 million for B. You’ll notice A’s Marketing budget is slightly less than 20% which is a result of using the proportion to calc the Marketing budget and then using that number in the Income Statement as opposed to using a straight 20%. But the difference is about ~$500K difference.
But we have an answer. B is able to generate almost 60% more revenue and roughly the same percentage more of EBITDA (correcting for the Marketing as noted above). That’s a MASSIVE difference! Better Capital Cycling has a huge impact on each company’s ability to use additional capital.
Of course this is napkin math and there are all sorts of improvements. For example, OpEx isn’t going to stay constant. Company B is likely to see even higher EBITDA margin %’s. And this also assumes that marketing efficiency stays constant at ~20%.
As an investor, our analysis does not stop there. What we ultimately care about, is how much can our $25 million improve valuation.
If each company receives the same multiple, let’s say a 10X, then Company B is creating $50 million in additional valuation.
But better Capital Cycling should earn a better multiple. PE firms call this multiple expansion. What experience shows is that companies with better financial metrics will earn higher multiples. In this case, while the margins are the same, Company B has far superior Capital Cycling. So, let’s say the market gives B a 20% better multiple. A keeps its 10X, but B gets a 12X which is a $78 million increase in valuation.
Remember, your company is a machine that generates returns from various capital inputs. Your job is to optimize your machine and your levers are increasing returns, improving capital cycling or both. Improving capital cycling can have massive impacts on your ability to generate profits (and cash), reducing your need for outside capital, improving your attractiveness to investors and increasing your valuation. So if you are looking to get your business to the next level, don’t just think about margins. Become a next level operator by figuring out ways to speed your capital cycles.
Note: heres the google sheet with the above tables and math.