After you have successfully bought a business, you need to have an appropriate amount of working capital to maintain the everyday operations. Working Capital is defined as the amount of cash required to operate a business efficiently.
I think it’s important to note that working capital can be something that your financial due diligence team supports as they’re diving into the financial statements so don’t feel like you need to have this ability to complete a deal.
Key Points To Note When Calculating Working Capital
- To calculate working capital, the buyer has to analyze the business’ balances in detail. It might be possible that some items under accounts payable may be no longer operational or relevant in nature which has to be then removed from the working capital.
- If the buyer thinks something is omitted from the balance sheet, the historical balances are adjusted to reflect those accounting errors. This helps calculate the true value of the needed working capital depending on the company’s revenue and EBITDA.
- The rationale behind calculating the working capital is that the valuation of a company is based on its revenue and EBITDA. Therefore, working capital is necessary to generate equivalent and consistent revenue and EBITDA.
Working Capital in Asset Sales
One of the most common ways acquisitions take place is through asset sales, i.e., the buying entity is acquiring the business’ assets instead of its stock or equity. This kind of asset sale is a debt-free and cash-free transaction in which all cash and debt remains with the seller. In accounting terms, it is calculated as:
Working Capital = Accounts Receivable (invoiced revenue that has not come in) – Accounts Payable (amount billed but not yet paid) + Inventory.
Working Capital in Stock Sales
In a stock sale, the buyer purchases the entire legal entity in stocks instead of buying the assets of that legal entity, the working capital is calculated a bit differently:
Working Capital = All Current Assets and Cash – Current Liabilities.
In this article, I will be unfolding the complexities of calculating the working capital and in the process explain why it is crucial for any buyer-seller transactions.
Establishing a Working Capital Peg
Calculating working capital is not always that simple. Both the buying and selling parties have to agree on the amount of working capital and the formula used for its calculation. Both the parties negotiate to establish a common ground because a company’s working capital often fluctuates from month to month.
Working capital is typically set on a “cash-free, debt-free” basis. This means that the seller keeps the cash and is responsible for any existing debt before the acquisition.
A working capital peg is the baseline working capital that the buyer and the seller agree to after at the end of financial due diligence. In simple terms, it means the amount that should be maintained by the seller on the balance sheet on the date of closing.
The 12-Month Average Formula
Sometimes, while acquiring a business, institutional investments like private equity firms establish a working capital peg that has to be included in the transaction. One of the most common ways by which parties agree on a working capital peg is through this formula:
- This working capital peg is calculated by looking at accounts receivable (AR) minus accounts payable (AP) plus inventory on a monthly basis. This is calculated for 12 months to arrive at an average working capital.
- Average working capital is where the negotiation for working capital starts. As a buyer, you can negotiate this value up and down depending on your estimated calculations. As a seller, you should be prepared to include this when setting an acquisition price.
On the other hand, it does not need to be included in smaller and Main Street transactions. Therefore, you can purchase a company for three times the seller’s discretionary earnings (SDE), and then add AR minus AP plus inventory.
No Textbook-Rule for Working Capital Peg Calculation
There is no rule book that decides how working capital is included in a deal. Keep the following things in mind when deciding upon the working capital:
- It makes sense to include it when it’s a small business going for multiple discretionary earnings (money that business brings) as opposed to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
- As a buyer, you need to take into consideration the size, value and SDE to decide whether you want to include the working capital in your offer or not. In most cases, working capital is included in the price offered for acquiring the business.
- Calculating working capital is primarily an unregulated industry. Everything depends on negotiation, i.e., how much you can get the seller to agree to. It is not a hard and fast rule and thus, largely depends on what both parties are willing to agree to.
Establishing Working Capital is Crucial
While acquiring a company, there are many things you look for, including the seller’s discretionary earnings (SDE) to understand the monetary value of that business, and the industry multiplier to assess the long-term value of the business.
Multiples are usually higher on EBITDA than seller’s discretionary earnings, but they include the working capital. It is a loose, gray area loosely somewhere between $5 million transactions up to $25 million transactions. In these companies, they might receive an offer for five times the EBITDA. In such transactions, the working capital needs to be included.
Working Capital Provides Key Business Insights
Working capital plays a crucial role in the transaction process as it provides key insights into the following:
- It is an important metric to determine the minimum cash flow needed to maintain daily operations of the business
- It represents the value to total assets and liabilities held by the business that will be transferred to the buyer during the transaction
- Working capital is used to calculate the free cash flow (FCF) which is used to compute the intrinsic value of the business.
In summary, there is no textbook rule on how to include working capital. However, both buyers and sellers are recommended to prepare a net working capital analysis while they are thinking of buying or selling their businesses.
Watch Walker as he explains what every buyer needs to know about working capital here: https://youtu.be/0EolqLC5Id4
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