From EBITDA less Maintenance Capex to Cash Conversion

After the business has paid for its assets, it still has to fund its customers and its stock. Every sale made on credit is cash the business has earned and not yet received. Every item on the shelf is cash spent and not yet recovered. Every supplier not yet paid is cash the business holds for a while. The net of the three is working capital, and a growing business has to keep adding to it. The second span of the third bridge deducts the change in working capital from earnings, and so reaches the first figure in the framework that a buyer can call cash.

What the measure is

The measure is EBITDA less capital spending less the change in working capital, usually summarized as cash conversion: the share of EBITDA that becomes cash. When conversion is high, the earnings are largely available to the people who finance the business. When it is low, the assets and the customers and stock the business has to fund are eating them.

It comes after the maintenance span because it is computed from it, and before taxes because the tax position depends on the entity structure, which comes next. A modelling buyer reads it before almost anything else, because adjustments can flatter EBITDA and nothing comparable flatters cash.

The three drivers

Working Capital Management decides, account by account, what working capital is, computes two years of it on that definition, sets a peg from the record with every adjustment written down, and gives receivables, payables and inventory each a target in days that a named seat manages weekly. Balance Sheet Quality checks that the balances behind the figure are real: receivables reserved from the business's own write-off history, stock counted and slow lines written down, revenue recognized only when the work is done, and every obligation a buyer will treat as debt listed in advance. Cash Visibility measures what results, with a monthly cash flow statement reconciled to the bank, a thirteen-week forecast rolled weekly against its own accuracy record, and cash conversion reported and explained each year and quarter.

Why this span carries the bridge

Most of the value on the third bridge sits in capital turnover, the revenue a business earns on each dollar of capital it carries, and this span is where most of that capital lives. A business that carries fewer days of receivables and inventory for the same revenue carries less capital for the same profit, and earns a higher return on what it carries. That is why Working Capital Management ranks first on the whole bridge. The cash it releases is real, arrives once and is often large, and the lower level it leaves behind reduces what every future dollar of growth absorbs.

The span also produces the most negotiated number in a sale at this stage, the working-capital peg: the level of working capital the seller delivers at closing. A shortfall comes off the price dollar for dollar, and an excess is paid for. A peg drawn from a documented history, with its seasonal curve explained, is a number both sides can agree quickly. When the peg is set from the worst month, or argued from scratch, the seller usually ends up paying for it with cash at closing.

In the illustration, a business that closes in December with $880,000 of working capital loses $180,000 of price against a peg set from its May peak of $1,060,000, and nothing against the $860,000 its documented curve expects for December.

What a buyer treats as debt

A buyer who values a business on its free cash flow reaches an enterprise value and then subtracts debt to reach the price of the equity. Debt here covers every obligation that will take cash after closing for value the business received before it, and owners rarely think of most of them as debt.

Bonuses earned last year and not yet paid, and holiday owed to staff, are obligations for work already done. Customer deposits and prepayments, to the extent of what it will cost to do the work they paid for, are obligations the buyer inherits. Supplier invoices paid far beyond their terms are borrowing by another name. Maintenance put off on the replacement plan is spending owed, and so are unpaid or disputed taxes, compensation deferred to a later date, earn-outs from an earlier acquisition, leases that behave like borrowing, and exposure to litigation or warranty claims. Each comes off the price dollar for dollar.

An item the seller has listed is part of the price from the start. An item the buyer finds in diligence comes off the price with a premium for the shock, and it tells the buyer to look harder at everything else.

Earnings borrowed from next year

One more distortion sits in revenue. A business that recognizes revenue before doing the work, invoicing a whole project up front and booking it all as earned, inflates this year's earnings at next year's expense. The cash may have arrived, but the work is still owed, and its cost falls on whoever owns the business next. A written recognition policy, with every deposit and prepayment matched to the job it pays for, the work still owed and the cost to finish it, keeps this year's earnings from being borrowed from the next.

How the drivers depend on each other

All three are built on one assignment of accounts. Working Capital Management decides once, in writing, which balances are working capital and which are debt-like, and Balance Sheet Quality builds its schedule of debt-like items from the same assignment, so nothing is counted twice and nothing falls between the two. Cash Visibility builds its cash flow statement from the classified capital spending of the previous span and the working-capital history of this one, so the conversion figure reconciles to both.

All three also depend on the second bridge. Working capital is a balance-sheet measure, so it needs two years of closed accrual balance sheets. Weekly management of receivables, payables and the forecast needs a finance seat with time for it, which an owner keeping figures in a notebook cannot supply. And days can only be managed against terms of trade someone wrote down, which Relationship Transfer did when it put every material customer and supplier under a company contract.

How the span comes undone

Working capital balloons as customers pay more slowly, stock creeps up and suppliers are paid early, and conversion falls without anyone deciding it should. Obligations that behave like debt accumulate off the schedule: a bonus promised, a deposit taken, a warranty claim pending. And the cash forecast stops being updated, leaving the business reading its bank balance again.

The safeguards, set out in each driver's essay, share one design. The days, the conversion ratio and the forecast's accuracy sit where the leads already look, in the monthly package and the weekly meeting. The reviews that catch stale balances and new obligations are signed lines on the close checklist. And credit holds and reorder points live in the systems, so they hold whatever the quarter.

Crossing the span

The span is crossed when a working-capital peg exists and receivables, payables and inventory are managed to it; when the receivables, inventory and debt-like items behind it would survive a quality-of-earnings review; and when cash is forecast every week. The next span takes the cash the business produces and asks what it pays in tax, and to whom the business being valued belongs.