Working capital is a measure of the capital a business uses during its day-to-day operations. This calculation is important because it gives an insight into the short-term financial health of the business.
Because the term working capital is sometimes used to mean current assets, it is instead preferable to use the net working capital. Net working capital is calculated using the difference between a business's current assets (cash, accounts receivable, and inventory) and its current liabilities (accounts payable).
In M&A, the value used is the non-cash net working capital. Cash is not counted under current assets because it can be removed from a business before a sale.
Working capital is important because it is a necessary investment in the business that cannot be removed. All things being equal, it is better if a business requires less working capital as this is more efficient. However, it shouldn't be negative, because this indicates the business is struggling to meet its obligations.
The Problem With Calculating Working Capital
Working capital is only useful when put into the correct context. It is a glimpse into a company's financial health taken at a particular moment in time. The problem is, the value can change quite drastically over time for legitimate reasons. These include seasonal fluctuations, changes in demand, and adjustments to payment terms.
Additionally, working capital is easy to manipulate because it depends upon inventory, the speed with which creditors are paid, and how aggressively outstanding invoices are pursued. Furthermore, the value itself must be put into context. A certain working capital may be considered fantastic in one industry and a poor performance in another.
For all these reasons, businesses negotiate a working capital target prior to M&A. This is an amount that is agreed to represent a fair value of what the business requires. A 12-month average is a common way of calculating this, but sometimes more or fewer months are used. The needs of a high-growth business, for example, might be better reflected by a 3-month average than a 12-month average.
How Does Working Capital Affect a Valuation?
The working capital target normally considered to be held in the business and is included in the purchase price. Of course, it is unlikely that upon the day of purchase the working capital held in the business will equal the agreed-upon target. When this happens, the valuation is adjusted to reflect the difference.
For example, if a company's working capital target is set at $1 million and upon purchase, it has a working capital of $1.5 million, there is a $500,000 working capital purchase. This $500,000 would be added to the purchase price.
If, instead, the same company had a working capital of just $650,000 at the point of sale, this would be considered insufficient for running the business. The $350,000 needed to make it up would be taken from the purchase price.
Why It's Important to Understand A Business's Working Capital
A failure to correctly understand the working capital necessary to run a business will result in that company being undervalued. A seller who fails to negotiate the working capital target effectively, or who does not spot when there is a surplus working capital, stands to lose out in a deal. They would effectively be giving the purchaser a discount. Similarly, a buyer may find themselves overpaying if they do not spot that a business has less working capital than is necessary.
