Calculating Net Working Capital: The Ultimate Deal Killer
Chris Barrett
What is Net Working Capital?
Business acquisitions often fail due to misunderstandings surrounding net working capital (NWC). Understanding how to calculate net working capital and managed can make or break a deal, especially when purchasing a business.
In this guide, we’ll explore why NWC matters, how to calculate it effectively, and what to consider during the due diligence process. Whether you’re a buyer or seller, understanding net working capital is critical to ensuring a smooth and fair transaction.
Why Does Calculating Net Working Capital Matter?
When buying a business, you’re purchasing a collection of assets expected to generate future cash flow. One of those key assets is net working capital.
If the business is delivered with insufficient working capital, the buyer will need to inject additional funds to cover operational needs. This effectively increases the overall purchase price.
To avoid overpaying, the purchase price should reflect a normalized level of NWC, ensuring the business has enough liquidity to continue operations without requiring immediate additional investment from the buyer.
How Is Net Working Capital Calculated?
Net working capital is calculated using the following formula:
Net Working Capital (NWC)=Current Assets−Current Liabilities\text{Net Working Capital (NWC)} = \text{Current Assets} – \text{Current Liabilities}
This formula provides a snapshot of the business’s short-term financial health. However, a simple calculation isn’t enough. To calculate a normalized level of NWC, several factors must be considered to ensure it reflects the business’s true operational needs.
A normalized NWC represents the amount of working capital the business has typically required over a period of time, taking into account seasonality, growth, and other operational trends.
Types of Adjustments in Calculating Net Working Capital
When calculating net working capital for a business acquisition, adjustments are often made to ensure accuracy. These adjustments fall into three main categories:
1. Definitional Adjustments
Definitional adjustments specify which items to include or exclude in most cash-free, debt-free transactions. Understanding what belongs in NWC is critical for making accurate calculations.
Generally Included:
- Accounts receivable
- Inventory
- Prepaid expenses
- Accounts payable
- Accrued salaries and wages
Generally Excluded:
- Cash
- Debt
- Debt-like items
- Investment accounts
- Unearned revenue
- Old accounts receivable or obsolete inventory
2. Due Diligence Adjustments
During due diligence, adjustments are made to reflect non-operating or non-recurring items, as well as differences in accounting methods. These can significantly impact the NWC calculation.
Engaging in discussions with management and performing a detailed analysis of the financials is crucial for identifying these necessary adjustments. Due diligence helps ensure that the buyer is not inheriting unexpected liabilities or overvaluing certain assets.
3. Pro Forma Adjustments
Pro forma adjustments account for recent changes in the business that don’t fully appear in the historical financials. For example, if the company recently extended its payment terms from net 30 to net 45, you must reflect this change in the NWC calculation to show its true impact on cash flow over time.
How to Set the NWC Peg
A common practice in business acquisitions is to establish a peg for net working capital based on historical data. Typically, a 12-month average of NWC is used to set this peg, but in certain cases, a different timeframe might be more appropriate.
- For fast-growing companies, where working capital needs are increasing, a 3-6 month average may be more suitable.
- In highly seasonal businesses, you may choose to exclude slower months or give them less weight in the calculation to arrive at a more accurate reflection of operational needs.
The goal is to establish a fair baseline so that both buyer and seller understand what level of working capital will be transferred during the sale.
How Is Net Working Capital Handled in a Transaction?
Handling NWC in a transaction can vary depending on the size and complexity of the deal. Here are three common ways it’s managed:
1. No NWC, Adjust Purchase Price
In smaller transactions, particularly when the seller doesn’t fully understand NWC, it may be easiest to exclude NWC from the transaction altogether. In this case, you’ll need to adjust the purchase price accordingly.
For example, if the enterprise value is $2 million and the business requires $500k in NWC, the purchase price would be reduced to $1.5 million. The buyer would then inject their own working capital post-acquisition, either through equity contributions or a bank loan.
2. Leave NWC in the Form of Current Assets
In deals where the seller agrees to leave some working capital in the business, you can negotiate for them to include current assets like accounts receivable, inventory, or even some cash. The simpler the negotiation, the better.
3. Post-Closing Adjustment
In larger transactions, a post-closing adjustment might be used. At closing, an estimated NWC is provided, and a few months later, the actual NWC is calculated. A true-up occurs to adjust the final purchase price based on the difference between the estimated and actual NWC.
It’s worth noting that this method is typically used in larger deals and is generally not allowed in smaller business acquisitions funded by SBA loans.
The Role of Quality of Earnings (QoE) Reports
An important part of any Quality of Earnings (QoE) report is the analysis of net working capital. A thorough QoE will:
- Summarize historical NWC to help set the peg
- Identify periods of potential cash crunches where a line of credit may be necessary
- Adjust NWC to remove any debt-like items or non-recurring assets
In summary, having a reliable QoE provider ensures that the buyer has a complete understanding of the working capital requirements before the transaction closes, helping to avoid post-deal surprises.
Conclusion: Calculating Net Working Capital Correctly Is Critical
Calculating net working capital is an essential part of ensuring a fair transaction during a business acquisition. Misunderstandings around NWC can cause deals to fail or lead to unexpected costs post-acquisition.
By understanding how NWC is calculated and the various adjustments required, buyers and sellers can approach negotiations with greater confidence. Whether you’re setting the peg or managing adjustments, accurate NWC calculations lead to smoother transactions and better outcomes for all parties involved.
Contact a due diligence professional at Midwest CPA to get help with your net acquisition.
Disclaimer
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.
