Working Capital in Business Transactions

Posted on December 16th, 2022 in Business Valuations

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Defining Working Capital

“Working capital” is the capital of a business which is used to fund day-to-day operations and meet shortterm obligations. In its most basic form, working capital is calculated as a business’ current assets, less its current liabilities.

However, in open market transactions and notional business valuations certain current assets and liabilities are often excluded when assessing the “operating” or net trade working capital of a business, such as cash, shareholder/related party loans, and other non-operational amounts. Cash is generally excluded from net trade working capital of privately held businesses unless the cash is used directly in the operations of the business, such as cash kept in cash registers in a retail business. This is because in most cases, the cash held in a business accumulates as a result of operations (i.e., through net income earned), and that cash is available to be either reinvested in the business or to be withdrawn by the owners, and is therefore not necessary in order to maintain the existing operations. In simple terms, net trade working capital is related to the operating activities of a business (excluding cash) such as accounts receivable, inventory, prepaid expenses, accounts payables, and accrued liabilities.

Calculating Working Capital

Determining which line items should be included in working capital may involve some judgment and is not always simple because the makeup of working capital can vary widely across different industries and even from business to business. This is why it is important to consider the specific nature of the operations of a business that impact how it employs working capital, as well as broader working capital issues that are common in the industry. Additionally, each component of working capital may need to be examined further to ensure all balances within the account are up-to-date, are operational and belong in working capital, and that the value reflected in the financial statements does not over or under-represent the asset or liability. Finally, the accounting standards used in the source financial statements should also be considered when calculating working capital, as balances on the balance sheet may be calculated differently depending on the accounting standards applied (i.e., GAAP, ASPE, IFRS).

Normalized Working Capital

In cases when the value of a business is determined based on its ability to generate future cash flows (i.e., using an income/earnings based methodology as opposed to an asset based methodology), the working capital that is required to operate the business is included in this value, and is not added to the value of the business. This is because the businesses requires the working capital to fund its continued operations and generate the level of income that this value is based. The amount of net trade working capital required to maintain ongoing operations is commonly referred to as the “normalized” net trade working capital amount.

Working Capital in a Business Sale

When a business is sold, it is common for the letter of intent between the buyer and seller to include general terms stating that the business will be sold with a sufficient level of working capital for the new owner to maintain operations. As the transaction advances, a specific amount of “target working capital” is usually agreed upon by both parties with corresponding definition on how the target working capital is to be calculated. This represents the amount that the buyer and seller agree is required to maintain operations, and that is expected to be left in the business at the time of closing. This target amount is based on an analysis of the company’s historical financial results, industry norms, ratio analysis, and benchmarks, and is ultimately determined through negotiations between the buyer and seller.

Working capital in a business at any one point in time is not always representative of the ongoing amount required. In some businesses and industries, the working capital required changes dramatically due to timing, such as large projects completed and invoiced, from month to month or year to year, such as businesses that experience seasonality or are in cyclical industries. For these types of businesses, it may be necessary to examine the average working capital requirement across different periods. Working capital balances may also be higher or lower than the required amount simply due to management’s own preferences. For these reasons, it is important to determine working capital requirements for a business on a normalized basis, which includes adjustments for seasonality or irregular changes that are not related to normal operations.

Implications on Price

When the amount of working capital left in the business on the day the sale of the business closes is different from the previously agreed upon target working capital amount, there is usually an adjustment made to the sale price to reflect this difference. In transactions where the actual working capital is less than the target, this negatively impacts the seller because the sale price is usually reduced by this amount. When the actual working capital is greater than the target, an increase to the sale price may be warranted. In a notional valuation context, a similar adjustment should also be considered if the working capital of the subject business is higher than or below what would be considered “normal” on the valuation date with a corresponding adjustment to the valuation conclusion of the shares.

The process for negotiating working capital in a business sale usually follows these broad steps:

A letter of intent is developed, outlining the broad terms agreed to by the buyer and seller. This usually includes an agreement that there will be a “normal” level of working capital in the business.
The buyer will analyze financial information about the business, which is supplied to them in order to better understand the working capital requirement of the business.
During the due diligence phase, both parties continue to analyze information about the business to determine any potential adjustments to working capital.
Through negotiations , b o t h parties will eventually come to an agreement on the “target working capital”.
A purchase agreement is drafted, and will further define how working capital is calculated and the target amount agreed to.
The purchase agreement is finalized, and additional clauses may be added outlining a post-closing dispute resolution process (including working capital disputes).
Post-closing , the buyer will determine the actual working capital level that was in the business at close and further discussions may take place between the buyer and seller to determine any post-closing adjustments.
If necessary, the dispute resolution process is initiated as outlined in the purchase agreement to remedy any disputes between the buyer and seller.

At DJB, our team of specialists have the professional experience to assist business owners and prospective buyers throughout the transaction process. Our trusted professionals can assist in many aspects of business sales and purchases, including assessing the complex issues involved in determining the value of a business and analyzing its working capital requirements.

Article originally published in: FSAT News: Fall/Winter 2022