If your business requires a significant amount of working capital to operate, then you must understand net working capital before you sell. NWC may constitute a significant percent of the purchase price, and any mistakes you make in the calculation or when negotiating terms will have a material impact on your net proceeds. For some sellers, this can amount to 20% or more of the purchase price.
Working Capital: A common accounting term, working capital is the difference between a company’s current assets and current liabilities, where current refers to a period of one year or less. In other words, working capital is a measure of a company’s operating liquidity – or its ability to fund operations and meet its short-term obligations.
Working Capital = Current Assets minus Current Liabilities.
Net Working Capital: More common in M&A, net working capital (NWC) is equal to working capital, less any cash and debt in the business. It’s sometimes called “non-cash working capital.” Most M&A transactions include working capital in the purchase price, but buyers don’t necessarily require all the current assets to run the business, such as excess cash in the bank account. And they don’t always assume all the current liabilities, such as lines of credit. Hence the different definition.
Net Working Capital = Current Assets (excluding cash) minus Current Liabilities (excluding debt).
In most M&A transactions, the target company is acquired on a cash-free, debt-free basis. This means the seller keeps the cash in the business and must pay off any debt upon closing. In a typical transaction, the purchase price doesn’t include cash, and the buyer doesn’t assume any debt.
Here’s a breakdown of the primary components of net working capital:
| Current Assets | |
| Included in net working capital | Excluded from net working capital |
| Accounts receivableInventory of finished goods, raw materials, or work-in-progressPetty cash (e.g., cash in registers required to operate a retail business)Prepaid expenses | Cash and cash equivalentsMarketable securities |
| Current Liabilities | |
| Included in net working capital | Excluded from net working capital |
| Accounts payable (e.g., supplier and vendor expenses)Accrued but unpaid expenses (e.g., payroll)Customer depositsDeferred revenue | Related-party itemsShort-term debtLines of creditTaxes payable |
Did you know that having a firm grip on net working capital, how it’s calculated and negotiated as part of the process of selling your business, can potentially save you millions of dollars? Not only that, but nasty surprises often come in the form of a purchase price adjustment three months after the closing. Yes, you read that right. As the seller, you may not know the actual purchase price until after the deal is done. In an episode of our M&A Talk podcast, my guest was involved in litigation around a $4m claim regarding working capital, and it’s clear the risks are easy to miss. If you want to avoid a million-dollar whammy and not leave millions on the table when selling, read on.
Working capital is a commonly used financial metric that represents the difference between a company’s current assets and its current liabilities. It’s not, as many business owners assume, the amount of cash they must maintain in their bank accounts to operate. Calculating net working capital is slightly more complex and requires a separate definition.
Net working capital, or NWC for short, offers a clearer picture or a more accurate estimate of a business’s ongoing operating expenses that buyers use to evaluate an acquisition. Properly calculating NWC is vital in M&A transactions because the acquirer must make sure the target business has a sufficient amount of working capital to continue to operate after closing. An insufficient amount would require the buyer to inject additional cash into the business, which increases the effective purchase price and reduces their return on investment. To prevent this, the purchase price in nearly all middle-market acquisitions includes a set amount of working capital, known as a net working capital target, or peg for short.
NWC targets are a frequently misunderstood concept in M&A and a common reason for post-closing disputes and litigation. Developing a working capital target that’s acceptable to both parties and clearly defining NWC in the purchase agreement are crucial steps in avoiding this.
The following describes how working capital is negotiated in a typical M&A transaction:
There are two major elements to negotiating NWC:
Working capital is necessary to maintain the ongoing operations of a business, so most sophisticated buyers include it in the purchase price when they submit an offer. This ensures they have enough working capital to operate the business post-closure and won’t need to inject extra money. NWC gives a buyer a clear idea of the level of capital required to keep the business running.
Working capital fluctuates for most businesses and is subject to manipulation. Agreeing on a target reduces friction between the parties by reducing the seller’s ability to manipulate it. The buyer and seller can agree on how much working capital to include in the purchase price without worrying about whether the actual amount will vary between signing the letter of intent (LOI) and closing.
A working capital target protects the buyer by reducing the purchase price if the amount of working capital is less at closing than the parties agreed to. Purchase price adjustments can also go in the seller’s favor if they deliver working capital above the target.
Calculating a working capital target is both an art and a science. The art lies in identifying normalizing, non-operating, and non-recurring items in working capital and determining to what extent these should be included or excluded in the calculation. Fortunately for the buyer, these are often identified during financial due diligence, giving them leverage to propose a target heavily weighted in their favor. What remains is a science: calculations are carefully identified and defined in the purchase agreement.
The working capital calculation should be based on a specific timeframe. Setting that timeframe depends on a couple of common methods of calculation.
The average period could be shorter – three or six months – if it better reflects the operations of the business or the near-future outlook. Rapid growth requires an additional infusion of working capital, so a calculation based on a historical timeframe would not be sufficient to support revenue in the months immediately following the closing. Best practice is to use a longer timeframe to smooth out any abnormalities, such as the impact of seasonality, rapid growth, or a decline in the business, all of which can affect the calculation.
The following is a sample calculation for a seasonal business with a busy period from May to August. Amounts are in millions, and the final column shows the last twelve months’ (LTM) average.
| Off Season | Busy Season | Off Season | |||||||||||
| Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sep | Oct | Nov | Dec | LTM Avg. | |
| Current Assets | |||||||||||||
| Accounts Receivable | $3.6 | $3.8 | $4.0 | $4.2 | $5.1 | $5.9 | $6.4 | $6.5 | $5.8 | $5.2 | $4.4 | $3.2 | $4.8 |
| Inventory | $2.1 | $2.1 | $1.9 | $1.7 | $2.1 | $2.3 | $2.5 | $2.6 | $2.0 | $2.1 | $1.8 | $1.1 | $2.0 |
| Prepaid Expenses | $0.6 | $0.6 | $0.6 | $0.7 | $0.9 | $0.9 | $0.9 | $1.1 | $1.1 | $1.0 | $0.9 | $0.9 | $0.9 |
| Total Current Assets | $6.3 | $6.5 | $6.5 | $6.6 | $8.1 | $9.1 | $9.8 | $10.2 | $8.9 | $8.3 | $7.1 | $5.2 | $7.7 |
| Current Liabilities | |||||||||||||
| Accounts Payable | $2.0 | $1.9 | $1.9 | $2.1 | $2.5 | $2.5 | $2.7 | $2.9 | $2.4 | $2.1 | $1.8 | $1.8 | $2.2 |
| Accrued Expenses | $1.1 | $1.1 | $1.1 | $1.4 | $1.4 | $1.4 | $1.4 | $1.5 | $1.1 | $1.1 | $1.1 | $1.1 | $1.2 |
| Total Current Liabilities | $3.1 | $3.0 | $3.0 | $3.5 | $3.9 | $3.9 | $4.1 | $4.4 | $3.5 | $3.2 | $2.9 | $2.9 | $3.4 |
| Net Working Capital (NWC) | $3.2 | $3.5 | $3.5 | $3.1 | $4.2 | $5.2 | $5.7 | $5.8 | $5.4 | $5.1 | $4.2 | $2.3 | $4.3 |
In this case, the average NWC is $4.3 million, which would be delivered to the buyer at closing.
Scenario #1 – NWC higher than the target
Scenario #2 – NWC lower than the target
Business owners can optimize cash flow, improve short-term liquidity, and reduce working capital by optimizing three primary areas – inventory, receivables, and payables.
Businesses with a positive working capital cycle usually require an infusion of capital or an operating line of credit to finance the period between paying for their inventory and receiving payment from customers. In the following example, Acme Chocolates’ inventory starts with raw materials:
Businesses with a negative working capital cycle can operate in a deficit. Acme Groceries receives immediate payment from customers when selling their goods and pay for inventory on terms:
Metrics such as days sales outstanding (DSO), days payables outstanding (DPO), and days inventory outstanding (DIO) flesh out a company’s cash conversion cycle. They are useful in estimating the amount and timing of cash flows and, therefore, of working capital.
But buyers are cautious and on the lookout for significant recent changes to these metrics, which may indicate manipulation and unsustainable change. So, any improvements should be made well before the sales process begins, should be clearly sustainable and, ideally, already maintained over several quarters.
Working capital fluctuates for most businesses throughout the year and is also subject to manipulation. For example, inventory can be rapidly sold off and reserves not replenished, accounts receivables aggressively collected by offering discounts, and prepaid expenses reduced. All such actions can reduce working capital in the short term, but they may not be sustainable over longer periods.
The seller could manipulate working capital in one or more of the following ways:
In M&A, buyers and sellers agree to a specific or set amount of working capital to be included in the purchase price. This is known as a target or “peg.” For example, a $50 million purchase price may include $5 million in working capital. If the amount of working capital delivered at closing is then calculated to be $4 million, the seller owes the buyer $1 million via a purchase price adjustment, or working capital adjustment.
So, using a defined target reduces friction between the parties. It means they can agree on how much working capital will be included in the purchase price without having to worry if the actual amount will vary between signing the LOI and the closing date. A working capital adjustment prevents it from being manipulated before then, and assures the buyer that enough capital will remain in the business to maintain operations. Working capital adjustments are crucial in situations in which working capital is subject to change before closing.
Negotiating the target is critically important. If the target is set too high, a seller could leave money on the table. Too low, and the buyer will have to inject additional cash into the business after closing.
A working capital target protects both parties. It protects the buyer by reducing the purchase price if the amount of working capital delivered at closing is less than agreed. And the seller will receive a higher purchase price, via a purchase price adjustment, if they deliver working capital above the target.
The target protects the buyer from other issues, too. For example, many businesses don’t maintain an allowance (or reserve) for bad debt, an omission the buyer may discover during due diligence. If maintaining a reserve is industry practice, an adjustment should be made to NWC to include one. If this adjustment isn’t made, working capital will be overstated by the amount of the reserve.
A working capital target protects both parties.
From a buyer’s perspective, working capital – which includes accounts receivable, inventory, and prepaid expenses – is necessary to maintain the ongoing operations of a business. It’s similar to any other asset required to operate. Most sophisticated buyers negotiate to include working capital in the purchase price when they submit an offer, and a wise one will negotiate to include a target to ensure it’s not manipulated or eroded before closing. This ensures the buyer has enough capital to operate the business from then on.
Sellers should consider the following when preparing for a working capital analysis:
If a seller tightens the working capital cycle several quarters before the sale, they demonstrate the change is sustainable. From a buyer’s perspective, this tightened working capital cycle reduces the risk associated with estimating the working capital target. The longer this new norm is maintained, the more likely the buyer will accept it. As the seller, every dollar you reduce the working capital before closing effectively goes into your pocket at the closing table.
You can tighten the working capital cycle in the following ways:
As a seller, every dollar you reduce the working capital before closing effectively goes into your pocket at the closing table.
The following are the major components of net working capital:
Most acquisitions occur on a cash-free, debt-free basis – the result is that cash and cash equivalents are not included in the calculation of working capital. The primary exception is petty cash for retail businesses.
Inventory is one of the largest components of net working capital, the other being accounts receivable.
When it comes to valuing the inventory, one of the key issues is whether the parties plan to physically conduct an inventory count at closing or rely on the business’s perpetual inventory-taking.
If inventory is counted on a perpetual system, the calculation can be rolled forward from the last physical count. In most cases, the buyer will diligence the accuracy of the perpetual system to accept this methodology.
A physical inventory count can be time-consuming, but not taking one at closing poses risks to the buyer. They may not be able to resolve stock issues later because inventory can’t be counted retroactively. On the other hand, if a buyer counts inventory on their own, the seller may challenge the methodology. In many industries, there are recommended third-party firms that specialize in counting inventory for you.
How inventory is valued is another key issue. The purchase agreement should address whether it is valued using FIFO (first in, first out) or LIFO (last in, last out), or the lower of cost or market value, and what’s considered obsolete or damaged inventory. Failing to clarify these points can lead to post-close disputes.
LIFO reflects a more accurate picture in an inflationary environment. The LIFO reserve account reflects the difference between LIFO and FIFO since the date LIFO was adopted. In an inflationary environment, this is a contra-inventory account and reduces the value of inventory. As a result, this increases the cost of goods sold and reduces EBITDA.
Most businesses carry a bad debt reserve on their financial statements. A reserve for bad debt is subjective to some degree, and many purchase agreements define how the reserve will be set for calculating working capital. Other businesses don’t carry a reserve and only write off bad debts as they occur. For them, it’s more appropriate to determine a suitable reserve and include it when calculating working capital.
If the strength of the accounts receivable is unknown, a formula may be used in which aged receivables are valued lower than newer receivables. For example, receivables less than 30 days old may receive 95% credit, from 30 to 60 days a 90% credit, from 60 to 90 days an 80% credit, and over 90 days a 50% credit. Past a certain number of days in aging accounts receivable, a buyer will likely not recognize the value of invoices and they’ll be written off. Or, the working capital can be calculated based on the receivables collected, though this may delay the true-up if they remain uncollected after it is scheduled.
The most common approach to valuing accounts receivable is to determine the receivables net of a general reserve for doubtful accounts. But, it’s important to understand on what basis the reserve was calculated so it can be updated for changes in the business. For example, if the reserve is calculated based on a percentage of total accounts receivable or revenue, it should be increased as the value of accounts receivable or revenue increases. Reserves can either be general, where they apply to all accounts receivable, or specific, where they apply to a single account receivable, such as one that’s slow-paying or otherwise in trouble.
For the seller, aggressively collecting your receivables is an opportunity to realize additional value, but only if you do so for several quarters before you begin the sales process. If your receivables are normally collected in 60 days – days sales outstanding, or DSO – and you manage to reduce this to 30 days, you have effectively put 30 days of receivables in your pocket at the closing table.
The largest component of working capital on the current liabilities side, accounts payable consists of outstanding invoices due to third parties, such as suppliers, vendors or contractors.
The challenge is determining which payables to include in calculating working capital. Ideally, the payables included should be listed in a schedule to the purchase agreement, and a formula should be agreed for defining how long a payable can be floated before it must be paid. This prevents the seller from delaying payables in an attempt to reduce working capital. While the actual amounts will change, the accounts and vendors will have been identified and a formula accepted to prevent disputes.
Many small to mid-sized companies don’t accurately track their payables. They may pay all invoices on delivery (COD) and carry few payables on their balance sheets, even though vendors may offer them terms of net 30. This allows sellers to realize additional value before they begin the sales process. As a business owner, you should stretch your payables as long as possible to minimize the amount of working capital required to operate. If vendors offer a discount for early payment, these savings must be weighed against the reduction in working capital.
Past a certain number of days in accounts payable, the buyer will consider those invoices effectively funded debt and exclude them from the calculation. To counter this, ask for full terms from vendors in writing and develop a pattern of paying invoices within the maximum term available.
The remainder of working capital consists of accrued expenses and liabilities. Accrued expenses are those you owe that have not yet been invoiced, or in some cases, won’t receive an invoice.
Examples include accrued employee expenses, such as vacation, paid time off, bonuses and other benefits, and utilities. Most smaller businesses don’t properly accrue expenses on their balance sheets, but it’s wise to do so consistently before you begin the sales process. This’ll help ensure an accurate working calculation and reduce potential disputes. Properly accruing expenses before the sale means you can make changes to your business to reduce the total accrued expenses, and therefore the amount of working capital.
For sellers, aggressively collecting receivables is an opportunity to realize additional value.
The working capital peg is usually first estimated at the LOI stage of an M&A transaction. This preliminary calculation is a starting point for the process and, like many terms in the LOI, isn’t legally binding. The final working capital calculation is made 90 to 120 days after closing and any difference is reconciled between the parties via a purchase price adjustment.
A working capital adjustment takes place 90 to 120 days after closing. This gives the buyer enough time to review the calculations and determine the amount actually delivered at closing. At this point, all accounts are closed – e.g., all accounts receivable have been collected – and the buyer can arrive at a more accurate working capital figure.
Several factors, such as seasonality and the timing of the closing, determine the time period on which to base the net working capital target. But what about best practices?
In most cases, buyers estimate working capital based on a historical average, typically an average and normalized or adjusted NWC for the trailing 12 months.
The average period could be shorter, such as the last three or six months, if such a period better reflects the operations of the business, or the near-future outlook. Best practice is to use a longer time period to smooth out any abnormalities, seasonality, rapid growth or decline in revenue, which can throw off the calculation. If the buyer is valuing the business based on historical EBITDA, working capital should also be measured using historical, not projected, financial information.
When calculating NWC, you should also consider how seasonal or cyclical the business is. In a three-month average, the calculation will be skewed depending on where it falls in the year. Timing of the closing may also impact the calculation. For example, in a large commercial cleaning business we represented, the sale closed in the off-season, and the accounts receivable was 80% down on the busy season. Luckily, in this transaction, we negotiated to exclude working capital from the purchase price, which is rare, but it allowed us to eliminate potential disputes regarding the timing of the calculation.
Calculating the working capital target is both an art and a science. The science lies in calculating the balances for all of the accounts that comprise it. Art comes into play in identifying normalizing, non-operating, and non-recurring adjustments to working capital and to what extent these should be included or excluded in the definition. Unfortunately for the seller, these adjustments are often identified by the buyer during their financial due diligence, which gives them leverage to propose a calculation weighted in their favor. A seller can counter this by undertaking a QoE analysis before the sales process begins. The QoE should include a working capital analysis, which will establish a favorable calculation and supporting narrative.
Let’s examine a sample calculation using a seasonal service business.
| Busy Season | Off Season |
| In the busy season, the balances might be as follows: |
Current Assets
Accounts receivable: $2,000,000
Inventory: $1,000,000
Prepaid expenses: $200,000
Total current assets = $3,200,000
Current Liabilities
Accounts payable: $300,000
Accrued expenses: $400,000
Total current liabilities = $700,000
Current Assets
Accounts receivable: $800,000
Inventory: $600,000
Prepaids: $100,000
Total current assets = $1,500,000
Current Liabilities
Accounts payable: $250,000
Accrued expenses: $250,000
Total current liabilities = $500,000
As you can see, working capital is 250% higher ($2.5 million vs. $1 million) in the busy season than the off-season. As the seller, if you haven’t defined working capital and how it’ll be calculated in the LOI, you’ve just written the buyer a check for $1.5 million because they’re sure to use the calculation based on the busy period.
Calculations based on the trailing 12 months will naturally factor out seasonality. But the amount of actual working capital delivered at closing will differ depending on when the purchase is made. If the transaction closes during peak season, working capital will be higher than average, and the buyer will need to inject cash at closing to sustain current operations. If the transaction is completed off-peak, working capital will be lower than average.
Another example includes a business that has made significant changes to its practices or activities in the prior 12 months that might affect the working capital accounts.
For example, the business may have won a new client by offering lenient payment terms. If the client was won recently, these terms may need to be accounted for in the working capital calculation. If management switched from a LIFO to a FIFO inventory valuation method, they may need to account for this too. There are numerous changes a business can make that affect the working capital required to operate or how it’s calculated.
To minimize the impact of any recent changes, I recommend not basing the working capital estimate on shorter periods as they may inadvertently favor one party or the other.
Most small to mid-sized businesses don’t strictly adhere to generally accepted accounting principles (GAAP), which leads one to wonder why they’re called generally accepted at all. Regardless, if the financials don’t conform to GAAP, then the monthly balance sheets may not include the necessary accruals to calculate working capital on a GAAP basis.
Working capital can also be analyzed on a historical basis as a percentage of revenue. For example, the working capital accounts can be calculated at the end of each month over the past six and compared with either revenue or costs of goods sold each month, and then a percentage established.
To prevent an erosion in value, it’s best, as the seller, to undergo a QoE analysis before you begin the sales process, and work to define working capital as clearly as possible in the LOI. Twelve months is the most commonly used timeframe as it incorporates seasonality in the business’s cash flow. If you own a seasonal business, it’s best to specify that an average of the last 12 months will be used as the basis for the NWC calculation, if you can get the buyer to agree.
A 12-month analysis isn’t usually appropriate if your company is rapidly growing. With growth comes a need for an additional infusion of capital. A working capital calculation based on the last 12 months would therefore not be sufficient to support the revenue in the months immediately following the close.
If revenue grew 50% in the trailing 12 months, the working capital delivered at closing would be higher than a target based on a 12-month average, resulting in a significant purchase price adjustment post-close.
For businesses with normal growth trajectories, the most common method to establish the NWC target is to take the average month-end balances of each working capital account over the past 12 months. Using the LTM average of each working capital account, you can then determine the average NWC for that period.
The following is a sample calculation for a business with a busy season from May to August. Amounts are in millions, and the final column shows the last twelve months’ (LTM) average.
| Off Season | Busy Season | Off Season | |||||||||||
| Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sep | Oct | Nov | Dec | LTM Avg. | |
| Current Assets | |||||||||||||
| Accounts Receivable | $3.6 | $3.8 | $4.0 | $4.2 | $5.1 | $5.9 | $6.4 | $6.5 | $5.8 | $5.2 | $4.4 | $3.2 | $4.8 |
| Inventory | $2.1 | $2.1 | $1.9 | $1.7 | $2.1 | $2.3 | $2.5 | $2.6 | $2.0 | $2.1 | $1.8 | $1.1 | $2.0 |
| Prepaid Expenses | $0.6 | $0.6 | $0.6 | $0.7 | $0.9 | $0.9 | $0.9 | $1.1 | $1.1 | $1.0 | $0.9 | $0.9 | $0.9 |
| Total Current Assets | $6.3 | $6.5 | $6.5 | $6.6 | $8.1 | $9.1 | $9.8 | $10.2 | $8.9 | $8.3 | $7.1 | $5.2 | $7.7 |
| Current Liabilities | |||||||||||||
| Accounts Payable | $2.0 | $1.9 | $1.9 | $2.1 | $2.5 | $2.5 | $2.7 | $2.9 | $2.4 | $2.1 | $1.8 | $1.8 | $2.2 |
| Accrued Expenses | $1.1 | $1.1 | $1.1 | $1.4 | $1.4 | $1.4 | $1.4 | $1.5 | $1.1 | $1.1 | $1.1 | $1.1 | $1.2 |
| Total Current Liabilities | $3.1 | $3.0 | $3.0 | $3.5 | $3.9 | $3.9 | $4.1 | $4.4 | $3.5 | $3.2 | $2.9 | $2.9 | $3.4 |
| Net Working Capital (NWC) | $3.2 | $3.5 | $3.5 | $3.1 | $4.2 | $5.2 | $5.7 | $5.8 | $5.4 | $5.1 | $4.2 | $2.3 | $4.3 |
In this case, the average NWC is $4.3 million, which would be delivered to the buyer on closing.
Scenario #1: NWC higher than the target
Scenario #2: NWC lower than the target
The following are additional items that should be considered when performing a working capital calculation:
Any change in accounting practices could significantly affect the NWC calculation.
There are two major elements to the negotiations:
The following can help when negotiating both the target and the formula:
When it comes to selling your business, details that seem small now can have a tremendous impact on the amount of cash you take away from the closing table. When it comes to the concept of net working capital, such details can become a ticking time bomb, set to explode even months after closing. If you aren’t keen on ticking sounds at your meetings, then it pays to educate yourself on the concept of NWC, and to take the advice outlined in this article when it comes to preparing your business for sale.
