Why is Working Capital So Important in a Deal?
Working capital is a vital component of exit strategy. Yet, when considering a potential transaction, working capital is often overlooked.
The Definition of Working Capital
Working capital is a measure of liquidity that gives an indication of the short-term health of the company. Working capital is calculated by subtracting current liabilities from current assets. A company’s level of working capital impacts value because changes in working capital impacts cash flow and valuation is inherently tied to cash flow.
The impact of working capital to cash flow is sometimes not understood by buyers/sellers. Assets are sometimes hard to value, and contingent liabilities may be missed as they may not show on the face of the balance sheet. Most importantly, buyers want to keep as much liquidity in the business after the deal and sellers want to pull out as much cash as possible before the deal closes.
How Working Capital Impacts Pricing
Working capital levels are important in determining the value of a company. Typically, an analyst considers three methods to determine value: the income approach, the market approach, and the asset approach.
- An income approach considers future cash flows
- A market approach considers the selling price of similar companies
- An asset approach considers the assets and liabilities of the company.
In calculating the net cash flows for use in the income approach, the analyst will make an adjustment for the increase in working capital that the company will need in order to fund its expected growth.
In addition, if there is an excess or a deficit of working capital as of the valuation date, the analyst may add or subtract this to the value of total equity. To determine these adjustments, the analyst will look at trends in the company’s historical working capital levels. The analyst will also compare the company’s working capital levels with similar companies operating in the same industry.
It’s never too early to consider business valuation.
How Working Capital Impacts the Deal Terms
It’s important that a buyer and seller negotiate how working capital will be treated in a transaction as it is often the cause of disputes. Defining what is included or excluded from working capital and how to set what is called a “Target Working Capital” is usually the first source of conflict.
Things like seasonality of revenue and expenses can cause fluctuations in working capital levels throughout the year. The value of assets may be hard to determine, or there may be one-off items impacting net working capital that would not be anticipated going forward.
Because the business continues to operate throughout the transaction process, closing estimated working capital will impact the purchase price on the date of closing. In the first few months after closing, there will be a true-up phase to bring that net working capital balance in line with actual. The true-up calculation itself is a second potential source of conflict. Disagreements may arise regarding specific balance sheet accounts, their values, methods for accounting for such accounts and their inclusion or exclusion from the true-up calculation.
There are several ways that management can maximize value and prevent problems in a transaction. Management can work to improve the efficiency of its working capital use and thereby improve its working capital turnover ratio. The working capital turnover ratio is calculated by dividing sales by working capital and indicates how well a company utilizes its working capital.
Management should keep monthly working capital records and analyze historical trends in order to avoid surprises during the transaction process. Management should project future working capital, keeping in mind a realistic expectation about the investment in inventory and accounts receivable that is required as the business grows.
The Importance of Working Capital
Working capital levels impact value and are important considerations in potential transactions. Sellers can increase company value by managing working capital levels and buyers can protect themselves against working capital deficiency with proper due diligence.