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Working capital is a critical element of any business operation. Often, it is implicit when determining the value of a company. This is especially true when it involves mergers and acquisitions.
The majority of M&A transactions involve the parties arriving at their purchase price by following a specific agreed-upon calculation. Typically, they will multiply the target company’s earnings before taxes, interest, depreciation, and amortization by a pre-agreed multiple. There are certain core provisions designed to protect the parties in M&A transactions, which include items such as third-party escrow, indemnification, and holdbacks. Often, there is also a requirement that there must be an absolute minimum “working capital” amount on the company’s balance sheet. This must be in place at the close of the deal, so the company experiences no immediate liquidity issues. But why is it so important, and how is it worked out?
Working Capital Defined
Net Working capital (NWC) is the difference between a company’s current assets and liabilities. NWC measures the liquidity of a company, as well as its financial health and operational efficiency. Having plenty of working capital indicates the company has potential for growth and investment. Conversely, negative working capital suggests the possibility of limited growth and possible financial problems.
The Working Capital Formula
One of the buy-side essentials is being able to work out a company’s working capital. A company can do this in the following way:
Subtract the current liabilities of a business from the company’s assets.
i.e., current assets-current liabilities = working capital
It is also possible to present working capital in a ratio format. Companies can do this by dividing the current assets of a company by the organization’s current liabilities.
For example, a company with $60,000 of current assets and current liabilities of $20,000 has a working capital ratio of 3. The ratio represents the number of times the company could pay its current liabilities off using current assets. This allows a business to measure its financial well-being in the short term. Companies with low ratios (i.e., one or under) could have financial difficulties.
How Is Working Capital Negotiated in M&A Transactions?
Both parties have to agree on the amount of working capital. They must then decide on the formula they will use to calculate working capital. While this may sound simple, it is often quite complicated. Often, parties negotiate acquisitions on a debt-free, cash-free basis. In such cases, they exclude notes payable, lines of credit, and cash. Purchase agreements must, therefore, define the liabilities and assets the parties will acquire that comprise the working capital of the deal. These could include loans, customer deposits, deferred taxes and revenue, and bank overdrafts.
Calculating Erratic Working Capital
Some companies have erratic working capital figures. For example, if customers make infrequent, large payments, banks require inventory in large lots, or vendor payment patterns fluctuate. Therefore, there are several things a company must consider in establishing a target for working capital:
- What is considered normal in this sector?
- What is the working capital when taken as a sales percentage?
- Which particular circumstances result in the working capital varying from its normal levels?
- Do seasonal sales affect working capital?
- Does the inventory significantly vary each month?
- Are both the business, as well as its working capital needs, experiencing growth?
Working capital represents a significant component when determining the health of any company and its value. However, negotiating the details can be complicated. Hence, it is often necessary to seek professional advice when it comes to mergers and acquisitions.
