Working Capital Matters in M&A Transactions
As a business owner, you know what working capital is, even if you rarely use the term. Working capital is the day-to-day cash that a company needs to run business operations. It is the difference between a company’s current assets and its current liabilities.
Working Capital = Current Assets – Current Liabilities
Different industries vary widely in their working capital requirements. Retailers vs. manufacturers is a classic example. Normally, a big box retailer rarely worries about accounts receivable: customers pay for goods on the spot. Inventories represent the biggest problem for retailers. If they aren’t skilled at rigorous inventory forecasting, they risk going out of business. Manufacturing companies, on the other hand, incur substantial upfront costs for materials and labor before receiving payment. Timing of payments is critical in that industry.
A company’s working capital provides an indication of its short-term financial health. The better a company’s working capital, the less likely it needs to borrow money to fund operations. When examining a business’s working capital, analysts often look at levels of inventory, accounts receivable, and accounts payable. Is the business able to pay its bills on time? Does it have access to the cash it needs to operate effectively?
Why working capital matters in M&A transactions
When evaluating opportunities, buyers will often require a normalized level of working capital so that the business can continue operating seamlessly and fulfill obligations to customers and creditors post-acquisition.
What that level should be is often a source of debate. One of the most challenging parts of any transaction is negotiating the amount of working capital that remains with the original business. Naturally, this can be an emotional topic for the seller, as they feel their business practices are being judged by an outsider who may or may not have sufficient industry experience. We encourage our clients to address this topic as early in the process as possible so that an agreement may be reached before the transaction has progressed too far.
In nearly all transactions, there will be some form of working capital adjustment as part of the purchase price agreement. An experienced M&A advisor can be instrumental in getting both parties to agree on how working capital will be calculated, making for a much smoother transaction. The goal of a working capital analysis, in our opinion, is to leave the buyer with sufficient working capital while ensuring the seller is paid for any excess working capital included in the transaction.
What is considered in a working capital adjustment?
Advisors will begin by looking at the selling company’s current assets (cash is typically excluded) over current liabilities on a monthly basis. This process will start with the current month and go back over the most recent 12 trailing months but could go back as far as the past 36 months. It is critical to understand the accounts receivables and how quickly the company collects revenue (and if all the accounts receivables will actually come in). It is also imperative to understand the current liabilities and the relationships associated with these debts. Advisors will keep in mind the type of business, industry, demand, market changes, competition, seasonality, and more.
Working capital is involved in every merger or acquisition transaction. If you are preparing to sell your business in the future, it is never too early to think about working capital and how it could impact your seller net proceeds. Incorrectly analyzing and calculating working capital could result in differences of hundreds of thousands of dollars, or more.
Please contact us for a confidential discussion of your specific situation. We have experience helping business owners across a variety of industries to sell their businesses, as well as relationships with buyers who are interested in new opportunities.