Understanding the Net Working Capital Formula — and Why It’s More Complex Than It Appears
On the surface, calculating the net working capital of a company is a basic formula: current assets – current liabilities = net working capital, but in M&A transactions, this very simple definition can be a complex, difficult, and important part of the transaction.
Yes, net working capital is the balance sheet difference between a company’s current assets and current liabilities, but more than that, it is a measure of a company’s operating liquidity and its ability to meet short-term obligations and fund the operations.
In M&A transactions, buyers will want to know the appropriate amount of working capital necessary to generate cash flows and run the business going forward. Buyers will also want to understand what working capital is needed for the business to set an appropriate working capital target at close.
Net Working Capital Definition
We have already defined working capital as current assets minus current liabilities. With most transactions, the company is acquired on a cash-free, debt-free basis, whereas cash and debt will not be assumed by a buyer at close, but rather retained by the seller. Therefore, in most M&A transactions, net working capital is defined primarily by four categories: accounts receivables, inventory, accounts payable, and accrued liabilities. These items are typically what is retained and assumed by a buyer at close.
It is important to correctly define and account for working capital before a transaction because an improperly defined or recorded working capital can lead to significant issues in financial due diligence and/or negotiations of the target working capital.
Some working capital items to prepare for before a sale transaction:
- Have financials audited or reviewed so that valuation methodologies for working capital are consistent with current accounting standards such as GAAP.
- Make sure extended AR is collected or normalized because collectability can be argued in a transaction and negatively impact the seller.
- Determine if inventory is properly booked, proper reserves are in place for obsolete inventory, and physical inventory checks have been conducted correctly.
- Review accrual policies, correct any improper accruals, or implement proper reserves. An example would be if vacation accruals are not properly accrued or even accrued at all.
Working Capital Target
Working capital can fluctuate in transactions; therefore, buyers and sellers will need to agree to a target working capital purchase price adjustment mechanism for closing. In other words, a working capital target is set that requires a certain amount of working capital be transferred to the buyer to keep the company operating in normal course. If at close, the seller delivers more working capital than the target, the seller will receive the positive adjustment or increase in purchase price. If the seller delivers less working capital than the target, the seller will owe the negative difference. Often, the working capital target will be a TTM average or calculated average of where working capital has been historically.
Having a defined target allows a more fluid negotiation with less friction as both buyer and seller can agree to how much working capital should remain in a business at close in order to maintain current operations. A working capital adjustment mechanism is also necessary for a transaction because a seller could manipulate working capital in their favor before a transaction is completed and deliver an inadequate amount of working capital at close.
A few examples of manipulating working capital:
- The seller could aggressively collect receivables outside of normal course collections and retain the cash from these receivables rather than allow the cash flows for post-closing and to fund future operations for a buyer.
- The seller could extend accounts payable so the burden of extended payables rests in the buyer’s hands.
- The seller could sell off inventory and retain the cash when the inventory is needed for current projects. The buyer would then have to provide capital for rebuilding inventory to complete projects. This action could also delay projects and cause conflicts for both employees and customers.
Post-Close Adjustment
The closing net working capital will be compared to an adjusted balance sheet or net working capital typically between 30-120 days later after close. Right before closing, the seller will calculate an estimated net working capital, which will be compared to the target and then trued up post-closing.
Having properly accounted for working capital and a properly defined working capital definition will allow for smoother negotiations over the working capital target and fewer adjustments after closing. It is important that sellers have the proper deal team of accountants, attorneys, and investment bankers to not only assist in properly calculating and defining net working capital but also to help assess and negotiate the target working capital purchase price adjustment mechanism.
If you have any questions, don’t hesitate to reach out to our team for guidance. Be sure to follow MelCap Partners on LinkedIn for more insights.
I'm an expert in financial transactions and M&A processes, and I'll demonstrate my expertise by providing in-depth information on the concepts discussed in the article "Understanding the Net Working Capital Formula — and Why It’s More Complex Than It Appears."
The net working capital (NWC) formula is a fundamental aspect of financial analysis, particularly in M&A transactions. On the surface, it's defined as current assets minus current liabilities, representing the liquidity available to a company for its day-to-day operations. However, the article rightly points out that in M&A transactions, this seemingly straightforward formula becomes a complex and crucial component.
In M&A, buyers focus on understanding the appropriate amount of working capital required for generating cash flows and running the business after the acquisition. The definition of net working capital in these transactions is influenced by four main categories: accounts receivables, inventory, accounts payable, and accrued liabilities. These are typically retained and assumed by the buyer at the close of the deal.
To avoid significant issues in financial due diligence and negotiations, it's crucial to accurately define and account for working capital. The article emphasizes the importance of preparing certain working capital items before a sale transaction:
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Financial Audits: Ensure financials are audited or reviewed to align with accounting standards like GAAP.
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Accounts Receivables: Collect or normalize extended accounts receivables to avoid issues in transaction collectability.
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Inventory Management: Verify proper booking of inventory, establish reserves for obsolete inventory, and conduct physical inventory checks.
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Accrual Policies: Review and correct any improper accruals, ensuring proper reserves, such as vacation accruals.
The concept of a "Working Capital Target" is introduced, acknowledging that working capital can fluctuate. Buyers and sellers need to agree on a target working capital purchase price adjustment mechanism for closing. This allows for a smoother negotiation process and helps both parties determine how much working capital should remain in the business post-transaction.
Manipulating working capital is highlighted as a risk, with examples such as aggressive collections of receivables, extending accounts payable, or selling off inventory. To counteract this, a post-close adjustment is conducted, comparing the closing net working capital to an adjusted balance sheet 30-120 days later.
In conclusion, having a properly defined working capital target and a well-structured deal team comprising accountants, attorneys, and investment bankers is crucial for successful negotiations and fewer adjustments after closing in M&A transactions. If you have further questions or need guidance, feel free to reach out.
