What is Net Working Capital?
Working capital also called net working capital, measures a company's financial security. According to Jensen and Meckling, authors of the new famous Theory of the Firm (1976), the components of working capital measure the firm's shareholder value. Working capital helps evaluate a company's short-term health, liquidity, and ability to invest and grow its operations. Working capital is defined as current assets less current liabilities. Current assets often include cash, accounts receivable, customer unpaid bills, and inventory, with current liabilities encompassing accounts payable and short-term debts, to name a few.
While the concept appears to be simple arithmetic, agreements between the buyer and seller on the financial accounts used in working capital can become a tenuous subject. A deal could fall through if the buyer and seller disagree on the seller's target working capital during financial due diligence. It is essential to understand which accounts are included in working capital and how certain aspects of working capital can become points of contention.
Working Capital In M&A & Why You Should Care
Transactions incurred in the lower middle market (LMM) are typically based on a cash-free, debt-free basis. Purchases in this market usually include most assets other than cash in the bank and any debt incurred on the company's balance sheet. A buyer assumes that they will receive a specified amount of working capital. As such, the process and threshold of calculating working capital are included in a letter of intent (LOI). The buyer and seller agree on how net working capital is measured at the beginning of due diligence.
The amount of working capital needed is not readily determinable until the financial due diligence has occurred. Most LOIs use unambiguous language such as "working capital threshold will be determined using a mutually acceptable methodology, which will be ultimately determined during financial due diligence."
Agreeing on the net working capital process and threshold is essential because the purchase price can be affected if it does not meet the threshold agreed to in the LOI. For example, if net working capital is higher than the threshold, the buyer may pay the difference, increasing the purchase price. If working capital is lower than anticipated, proceeds are withheld to balance the deficit, effectively lowering the purchase price. Therefore, networking capital at the conclusion of due diligence can impact cash paid to the seller and is an important factor to consider when maximizing seller value.
Calculation and Limitations
The working capital formula is "working capital = current assets – current liabilities." Typically, when calculating working capital, between 12-24 months of the most current balance sheets are used to arrive at an average working capital number. The specifics of which accounts are included and the length of time are agreed to in the LOI. While due diligence times vary, the typical time is around 60-120 days from kick-off (once both the buy-side and sell-side have executed the LOI). Since companies continue operating during this process, working capital tends to fluctuate due to shifts in assets and liabilities.
The types of assets and liabilities on the company's balance sheet are also important. For example, if the company's current assets are primarily derived from accounts receivable, its financial health depends on the customers paying the company, which could mean short-term cash issues. A top customer could also file for bankruptcy, distributing accounts receivable and impacting working capital. Working capital also relies heavily on correct and timely accounting processes. With some transactions occurring quickly, failure to conduct proper accounting practices and ensure that invoices, debts, and other account items are adequately accounted for could result in the buyer underpaying and terminating the LOI.
Improving and Preparing Working Capital
By definition, the way to increase working capital is to increase the company's current assets and reduce its current liabilities. This can be achieved by prepaying expenses and monitoring credit terms with clients. Current liabilities can be reduced by eliminating unnecessary expenditures and avoiding debt if owners are preparing to place the company for sale.
As a seller, it is crucial to ensure that the company's financial statements are as accurate as possible. Utilizing top talent internally, hiring an accounting firm to provide audited/reviewed statements, and hiring financial advisors to help navigate the company to the necessary position it needs to be to maximize valuation. A buyer should have an internal financial team or hire a reputable financial due diligence team to review the prospective company's financial information. To evaluate its accuracy, buyers should ask in-depth questions about how a company conducts its internal accounting processes.
In short, working capital provides buyers with a clear understanding of a prospective company's short-term financial health and is the bedrock from which a seller's company will be evaluated. It is vital to have suitable representation when negotiating, to calculate, and discussing working capital to gain the most from the sale.
Jalbert, D. (2022). Understanding net working capital in M&A. Mergers and Acquisitions, 57(2), 38-39.
Boisjoly, R. P., Conine, T. E., & McDonald, M. B. (2020). Working capital management: Financial and valuation impacts. Journal of Business Research, 108, 1-8. https://doi.org/10.1016/j.jbusres.2019.09.025
Fernando, J. (2022, June 29). Working Capital: Formula, components, and limitations. Investopedia. Retrieved August 30, 2022, from https://www.investopedia.com/terms/w/workingcapital.asp
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