Article

The Importance of Working Capital from an M&A Perspective

By Welch Capital Partners on
May 19, 2023

From a mergers and acquisitions perspective, net working capital is important, as it can either increase or decrease the purchase price of a transaction at close or within a reasonable period post close.

A buyer will want to ensure that there is sufficient working capital remaining in the business so they can continue to run the company with little to no cash injection on day one of the transaction.  The seller will want to ensure they are being rewarded for their effective management of working capital with the ability to remove any excess from the business pre-close.

What is Working Capital?

Working capital is the lifeblood of any business. It is calculated as the difference between current assets (such as cash, inventory, and accounts receivable) and current liabilities (such as debts and payables).

Adequate working capital is important because it provides a company with the liquidity necessary to meet its short-term obligations, pay employees, and maintain day-to-day operations. Without enough working capital, a company may struggle to survive, and may even go bankrupt.

A company often must balance the need for liquidity with the need to optimize the use of funds, which can be challenging.  For example, when a business has too much inventory, it ties up its working capital and reduces its ability to invest in growth. If a company has a poor credit management policy in place and is not collecting its payments from their customers in a timely manner, that could impact the company’s ability to pay its employees and suppliers.

Target Net Working Capital ("NWC")

In a mergers and acquisition transaction a target net working capital is negotiated.  The seller and the buyer must agree on the definition of working capital and how it is calculated.  While there are multiple ways to arrive at the target NWC, the most common we tend to see is the trailing twelve months average.

Once the target NWC has been established, this target then forms the basis for the adjustment to the purchase price at the close of the transaction.

Illustrative Example.

Negotiated target working capital: $1,000,000.

Deal close: May 31st; final net working capital adjustments due with 90 days or August 31st. 

@ May 31st
Estimated net working capital @ May 31st $1,200,000
Target net working capital @ May 31st $1,000,000
Estimated Increase to the Purchase Price $ 200,000
@August 31st (90-day true up period)
Actual net working capital @ May 31st $1,100,000
Target net working capital @ May 31st $1,000,000
Actual Increase to the Purchase Price $ 100,000

Essentially, if the calculated working capital is greater than the target at close, the buyer will increase the purchase price by the delta.  If the working capital is less than the target at close, the purchase price will be adjusted downwards.

Generally, the seller is given between 90 and 120 days to close out the accounting records/books and reconcile the working capital, with a further adjustment to working capital made at that time.

A seller will always want the working capital target to be the lowest possible, ensuring they can take out any excess working capital balances that were not invested back in the business before selling.  The buyer will want the working capital target to be high, ensuring they have enough of a runway to cash flow the business properly.

In conclusion, working capital is critical in an M&A deal as it can have a significant impact on the overall value the business owner is receiving.  Understanding your company’s working capital trends and ensuring you are managing your working capital efficiently can have a material effect on the sale of your business or the successful outcome of an acquisition.

For additional insights on working capital and its impact on your valuation please contact, Candace Enman at cenman@welchcapitalpartners.com

From a mergers and acquisitions perspective, net working capital is important, as it can either increase or decrease the purchase price of a transaction at close or within a reasonable period post close.

A buyer will want to ensure that there is sufficient working capital remaining in the business so they can continue to run the company with little to no cash injection on day one of the transaction.  The seller will want to ensure they are being rewarded for their effective management of working capital with the ability to remove any excess from the business pre-close.

What is Working Capital?

Working capital is the lifeblood of any business. It is calculated as the difference between current assets (such as cash, inventory, and accounts receivable) and current liabilities (such as debts and payables).

Adequate working capital is important because it provides a company with the liquidity necessary to meet its short-term obligations, pay employees, and maintain day-to-day operations. Without enough working capital, a company may struggle to survive, and may even go bankrupt.

A company often must balance the need for liquidity with the need to optimize the use of funds, which can be challenging.  For example, when a business has too much inventory, it ties up its working capital and reduces its ability to invest in growth. If a company has a poor credit management policy in place and is not collecting its payments from their customers in a timely manner, that could impact the company’s ability to pay its employees and suppliers.

Target Net Working Capital ("NWC")

In a mergers and acquisition transaction a target net working capital is negotiated.  The seller and the buyer must agree on the definition of working capital and how it is calculated.  While there are multiple ways to arrive at the target NWC, the most common we tend to see is the trailing twelve months average.

Once the target NWC has been established, this target then forms the basis for the adjustment to the purchase price at the close of the transaction.

Illustrative Example.

Negotiated target working capital: $1,000,000.

Deal close: May 31st; final net working capital adjustments due with 90 days or August 31st. 

@ May 31st
Estimated net working capital @ May 31st $1,200,000
Target net working capital @ May 31st $1,000,000
Estimated Increase to the Purchase Price $ 200,000
@August 31st (90-day true up period)
Actual net working capital @ May 31st $1,100,000
Target net working capital @ May 31st $1,000,000
Actual Increase to the Purchase Price $ 100,000

Essentially, if the calculated working capital is greater than the target at close, the buyer will increase the purchase price by the delta.  If the working capital is less than the target at close, the purchase price will be adjusted downwards.

Generally, the seller is given between 90 and 120 days to close out the accounting records/books and reconcile the working capital, with a further adjustment to working capital made at that time.

A seller will always want the working capital target to be the lowest possible, ensuring they can take out any excess working capital balances that were not invested back in the business before selling.  The buyer will want the working capital target to be high, ensuring they have enough of a runway to cash flow the business properly.

In conclusion, working capital is critical in an M&A deal as it can have a significant impact on the overall value the business owner is receiving.  Understanding your company’s working capital trends and ensuring you are managing your working capital efficiently can have a material effect on the sale of your business or the successful outcome of an acquisition.

For additional insights on working capital and its impact on your valuation please contact, Candace Enman at cenman@welchcapitalpartners.com

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