When Working Capital ≠ Current Assets - Current Liabilities
By Kenneth B. Collins
Yes, we all know the correct definition of working capital, but when you’re
buying or selling a business, the formula is never that simple. The buyer wants
as much as he can get, and the seller wants to keep it all, so the balance sheet
rarely transfers from seller to buyer without adjustment to the purchase price –
regardless of whether the transaction is structured as a sale of assets or stock.
The point of agreement between seller and buyer is often “normalized” or
“adequate” working capital – that is, the amount of current assets, net of
current liabilities, needed to operate the business, typically based on an
historical review of the operations over a specified period of time.
Once the target working capital amount is defined and agreed, it can be
compared against the actual working capital at the closing, which serves as a
formula to either increase or decrease the purchase price. Hence the concept of
normalized working capital benefits both parties. The seller leaves the buyer
only the required levels of working capital at the closing, retaining the excess –
and the buyer is reasonably assured that he will have adequate working capital
to meet the requirements of the business post-closing.
As a rule, all cash (and cash equivalents) on hand at the closing is considered to
be an “excluded asset” – i.e., it is retained by the seller. My mantra: “Never sell
cash for cash.” In concept at least, businesses do not need cash in order to
operate. On the morning after closing, the new owner opens the mail and
deposits customer checks; and that afternoon, he pays the bills. Overdrafts and
lines of credit are there to help through times of imbalance, and as cash builds,
liquidity increases to ease the pressure.
There are two basic steps in the working capital adjustment analysis:
1. Identify all accounts and amounts from all balance sheets that both sides
agree are to be “excluded” from Current Assets (e.g., cash, loans due
from owners); and those excluded from Current Liabilities (e.g., bank debt
and taxes payable). These accounts are excluded from the adjustment
calculations and from the transaction; all such accounts and amounts are
normally retained by the seller.
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2. Typically, the balance sheet accounts that remain are accounts receivable,
inventory, and prepaid expenses; and accounts payable and accrued
expenses. The difference (current assets minus current liabilities) is what
I call “net” working capital. Averaging those amounts for, say, the
previous 12 months frequently defines the amount of “Target Working
Capital.”
The Target Working Capital amount is then compared to the actual amount of
net working capital (similarly calculated) on the closing balance sheet. If the
actual net working capital is higher than the Target, a price adjustment is made
in favor of the seller. If lower, then the adjustment is in favor of the buyer.
There is sometimes a third step as well – adjusting for deferred revenue, which
may be considered deposits, that is, billings to customers in advance of
providing the product or service. The adjustment concept here is simple: If the
seller pre-billed customers for products or services which the buyer is
responsible to provide after the closing date, then the seller should reimburse
the buyer (via the working capital adjustment or directly as an adjustment to the
purchase price) either by paying over the full amount of the payments received
or, at a minimum, by reimbursing the buyer for the estimated cost of his
providing those products and services. Note that any portion of the deferred
revenue that remains in accounts receivable will automatically flow to the buyer
post-closing as payments are received and should therefore be excluded from
the calculations.
Separately, and as part of the buyer’s due diligence, buyers will test (and
adjust!) for things like the aging and collectability of accounts receivable,
marketability of inventory, aging of accounts payable, adequacy of expense
accruals, etc. – so it is important to address these issues well in advance of even
going to market.
Similarly, to the extent that any pro forma adjustments have been made to the
income statements that have an impact on the company’s balance sheets – for
example, a discontinued product line – it is also important to make pro forma
adjustments to the working capital accounts prior to calculating Target Working
Capital and completing the adjustment analysis.
Ken Collins is a Managing Director with Protegrity Advisors, LLC, an M&A
Advisory firm based in Ronkonkoma, NY. He may be reached at (631) 285-3174
or via email – KCollins@ProtegrityAdvisors.com.
www.ProtegrityAdvisors.com
4175 Veterans Memorial Highway, Suite 400, Ronkonkoma, NY 11779