Working Capital

In many M&A transactions, there is a working capital adjustment mechanism to ensure that the buyer receives a business with an appropriate level of working capital to continue its operations effectively. This mechanism may involve establishing a target working capital amount based on historical averages or industry standards. If the actual working capital at the time of closing deviates from the target, an adjustment is made to the purchase price to reflect the difference.

Working capital adjustments are typically made by increasing or decreasing the purchase price, depending on whether the actual working capital is higher or lower than the target. This ensures that the buyer is not taking on more or less working capital than originally anticipated.

The definition and treatment of working capital in an M&A deal can be complex and should be clearly outlined in the purchase agreement to avoid disputes and misunderstandings between the buyer and seller. Additionally, tax advisors, legal experts, etc. are often involved in assessing and negotiating working capital terms in M&A transactions.

Net Working Capital is an Operating Asset

Net Working Capital (NWC) is a reflection of the capital (money) employed in the business to support the ongoing operations. -- the process by which a business buys and sells inventory, pays suppliers and collects from customers.

Buyers view working capital as an important operating asset of a company. Operating assets are those assets used in the conduct of the ongoing operations of a business. These are assets which support the core business operations (and day-to-day functions). This means assets that are needed to support the generation of revenue.

When a buyer makes an offer to purchase a company, the buyer expects to receive all of the operating assets in the business which includes an appropriate amount of working capital.

Reasons Why Working Capital is Classified as an Operating Asset

1. Funding Operational Need: Working capital consists of current operating assets (e.g., accounts receivable and inventory) and current operating liabilities (e.g., accounts payable and accruals) that are essential for running the business. These assets and liabilities directly support the company's daily operations, such as paying suppliers, covering payroll, and managing inventory levels.
2. Drives Revenue Generation: The cash invested in working capital is used to maintain inventory levels, extend credit to customers, and ensure the smooth flow of goods and services. These activities contribute directly to revenue generation and profit generation.
3. Sustaining Cash Flow: The components of working capital are crucial in maintaining healthy cash flow. Cash on hand can be used to cover immediate expenses, while accounts receivable represent future cash inflows and accounts payable represent future cash outflows, both are vital for a business's liquidity.
4. Managing Seasonal and Cyclical Fluctuations: Operating assets like working capital help businesses manage seasonal and cyclical fluctuations in cash flows and operational needs. For instance, a retailer may require higher inventory levels and accounts receivable during the holiday season, and working capital facilitates this.
5. Financial Stability: Adequate working capital contributes to the financial stability of the business. It provides a cushion against unforeseen expenses, economic downturns, or other financial challenges that may arise. Without sufficient working capital, a company may struggle to weather financial storms.
6. Calculations of Net Asset Value: In M&A transactions. Working capital is often factored into the calculation of the target company's net asset value. This valuation method considers both operating assets (e.g., working capital) and non-operating assets (e.g., real estate) to determine the overall value of the business.
7. Risk Assessment: The buyer assesses the business's working capital as part of the due diligence process to evaluate its operational and financial risks. An insufficient level of working capital could be a red flag, indicating potential issues with liquidity or financial mismanagement.
8. Negotiation and Purchase Price Adjustment: The inclusion of working capital in the M&A deal allows for the negation of a fair purchase price. If the actual working capital at the closing date deviates from the target, it can lead to purchase price adjustment, ensuring that the buyer pays a price aligned with the operational needs of the business.
9. Business Continuity: Ultimately, the classification of working capital as an operating asset highlights its role in ensuring business continuity. Without sufficient working capital to cover operational expenses, a business may face disruptions, strained relationships with suppliers and customers, and a decline in its overall performance.

General Formula to Calculate Operating Working Capital

M&A Working Capital is referred to as Net Operating Working Capital to clearly differentiate it from Textbook Working Capital. It is also referred to as Net Working Capital to specifically recognize its role as an operating asset. M&A transactions are most often structured on a cash-free debt-free basis with the outcome being that net working capital is calculated based on operating assets and operating liabilities.

So, in an M&A transaction, the terms Net Working Capital and Net working Capital often have the same meaning and be used interchangeably. As a result, the parties will generally reference working capital as ==> Net Working Capital.

Trailing Period Approach

The most commonly used method and most practical approach of setting net working capital targets is to calculate a historical average amount of net working capital needed to fund a company's operations. This is often done by calculating the average net working capital on a monthly basis over a period of time. Calculating an average over a historical period removes any seasonality effects and reveals a "normalized" level of net working capital needed to support the company's ongoing operations with no capital disruption.

In arriving at an average, historical data should first be analyzed. Business valuations typically incorporate analyzing three to five years of historical operating data. Likewise, proper analysis of historical working capital trends should be done over a similar period. This allows a comparison of historical actual results to be compared to the period of time being used to develop the net working capital target.

When calculating a Net Working Capital Target for an established business in the context of an M&A transaction, a historical trailing period of 12 months is often considered the standard and is typically recommended. Here's why:

1. Comprehensive View: A 12-month period provides a comprehensive and complete view of the business's working capital needs across different market conditions.
2. Seasonality and Cyclicality: Even established businesses might have certain seasonal or cyclical patterns affecting their working capital. A full-year review ensures that these variations are accounted for in the analysis.
3. Identifying Trends: Examining a year's worth of data allows for the identification of trends and patterns in working capital components such as accounts receivable, inventory levels, and accounts payable. Detecting trends is crucial for understanding the stability and predictability of the business's financial operations.
4. Industry Norms and Yearly Cycles: Many industries operate on yearly cycles, with financial planning, budgeting, and performance evaluations structured around annual periods. Using a 12-month historical review aligns with industry norms and makes it easier to benchmark the business against competitors and industry standards.
5. Stability Assessment: A 12-month historical review helps assess the stability of working capital needs over a more extended period. It can identify any trends or patterns in the business's working capital components, such as accounts receivable, inventory, and accounts payable.

While a 12-month historical review is the standard, it's essential to consider any specific circumstances or industry peculiarities. In some cases, especially for businesses with minimal seasonality and stable operations, a shorter review period might suffice. However, the choice of the historical review period should be transparent, agreed upon by both parties, and documented in the purchase agreement to ensure clarity and fairness in the transaction.

THIELGROUP does not provide legal, tax, or accounting advice and strongly advises its clients to seek independent tax & legal advice from professionals who possess an expertise in business transactions.