Working Capital is a Crucial Financial Metric in Business Transactions

2024-07-23

A company’s working capital is calculated fairly simply by subtracting its current liabilities from current assets. The resulting amount is the working capital.

Despite the simplicity of the calculation, the importance of working capital to a business’s operations is substantial since it represents its ability to meet day-to-day operating expenses. Moreover, working capital is a crucial financial metric that plays a significant role in business transactions, particularly mergers and acquisitions (M&A).

Working capital is important because the net profit shown in a profit & loss (P&L) report does not necessarily reflect the amount of cash available in a business. Net profit is what is left over after considering a company’s expenses. However, the working capital figure represents the amount that will translate into cash used to operate the company.

The benefits of having a strong working capital position include financial stability, improved cash flow, increased flexibility in financial planning, better supplier relationships, and reduced borrowing costs. These factors contribute to keeping expenses down and adding stability to the company’s operations.

Impact on Liquidity

In an M&A negotiation, a potential buyer will consider working capital in assessing a company’s liquidity, efficiency and cash flow management. In a typical cash conversion cycle, cash is used to pay for raw materials, and the raw materials are converted to finished goods, which are sold on cash or credit and received as cash. The positive value of working capital signifies that the company has the resources to meet its operating expenses. A negative or lower value could mean the company is unable to meet current obligations, necessitating borrowing. So working capital is an important indicator of a company’s short-term liquidity and overall financial health.

To illustrate how the working capital number is reached, consider XYZ Inc., which has $250,000 in cash, $100,000 in short-term securities, $200,000 in receivables and $150,000 in inventory. The company also has current liabilities of $420,000.

So XYZ’s current assets equal $700,000 and its current liabilities total $420,000, pegging its working capital at $280,000.

For purposes of calculating working capital, the following items generally are included as assets and liabilities:

Examples of Assets

• Cash
• Prepaid expenses
• Short-term investments
• Accounts receivable
• Inventory

Examples of Liabilities

• Accounts payable
• Taxes
• Current portion of notes payable, including short-term loans, accrued expenses, salaries/wages payable and deferred revenue

Determining Working Capital During Negotiations

During negotiations over a business transaction, the target working capital calculation is typically reached during the due diligence phase. Common methods include using the average month-end balances of each working capital account over the last twelve months. The goal is to determine the average net working capital for that historical period.

During the closing phase, the working capital estimate is reached for the closing calculations. Then in the post-closing stage, a reconciliation process occurs to compare the actual received working capital with the agreed-upon target.

Benefits of the Net Working Capital Analysis

A comprehensive working capital analysis can help minimize disagreements and distractions during the negotiation, due diligence, and closing stages of a business transaction. It can also help evaluate the quality of current assets and assess post-transaction operational needs.

Understanding and managing working capital are essential for a successful M&A process, as they impact both parties’ interests and the overall transaction outcome.

We’re Here to Help

For more information or a discussion about how a working capital analysis may impact a transaction you are considering, contact your JLK Rosenberger team member or call us at 818-334-8625 or click here to contact us. We look forward to speaking with you soon.