Understanding Working Capital
December 14, 2023 · 3 mins
What is Working Capital?
Working capital is the difference between current assets and current liabilities. It represents the capital required to run the day-to-day operations of a business and meet short-term obligations, such as payroll, rent, utilities, inventory purchases, etc.
Working capital is considered to be a component of business value and is therefore included in the sale of a business.
Why is it Included in the Sale of a Business?
There are sellers who believe accounts receivable, inventory, deposits, etc. belong to them, and therefore the buyer should pay for these assets on top of the purchase price. However, amongst other factors, these assets are the reason that the business is able to generate revenue through providing services, selling products, and providing value to its customers. The value of these assets is reflected in the earnings of the business which drives business value and at the end of the day, the sales price of a business.
What Amount of Working Capital is Included in the Sale of a Business?
A working capital target will be included in a letter of intent (LOI). The LOI should include a clearly defined approach for how working capital will be treated in the purchase and sale agreement.
Working capital requirements vary significantly from industry to industry and business to business and can fluctuate throughout the year for each business. One approach to determine the target is to look at the trailing 12 months (TTM) of balance sheets. This provides a glimpse of where working capital lands throughout the year and offers insight into seasonal fluctuations. Having sound financial information is critical to provide backup as to where the working capital target lands.
Some sellers make the argument that their working capital is higher than it needs to be and that the buyer should compensate them for this. A working capital analysis to dive deeper is required to understand the mechanics of working capital in anticipation of a discussion with a potential buyer. A case can be made when there is clear evidence showing that working capital is higher than it needs to be. However, without clear evidence, it may be difficult to convince the buyer and their lender to take the seller’s word that working capital is higher than it needs to be. As a seller, it’s very important to manage working capital diligently leading up to the sale of the business.
Working Capital on Closing Date vs. Target Working Capital
The difference between the actual working capital on the closing date and the target working capital will lead to a purchase price adjustment. The mechanics of the adjustment should be clearly defined in the purchase and sale agreement. If actual working capital is less than the target, then there would be a purchase price adjustment in the buyer’s favor. If actual working capital is greater than the target, then there would be a purchase price adjustment in the seller’s favor.
Resolving Working Capital Disputes
Disputes regarding working capital are not uncommon. Clear documentation and well-drafted purchase and sale agreements are key. Disputes may be resolved through negotiation, mediation, or by following predetermined mechanisms detailed in the purchase and sale agreement.
Working capital is an important piece of every M&A transaction. Developing a working capital target and having a clear understanding of the components of working capital in an LOI and purchase and sale agreement are essential to every transaction.
For business owners considering a sale in the upcoming years, proactive year-round management of working capital is a major factor that will help pave the way to a smooth transition of your business.
Peter MacSwain
peter.macswain@confederationgroup.ca
