Net working capital (“NWC”) is a crucial financial component of middle-market M&A transactions. Understanding the impacts NWC has on an M&A transaction is important and can alleviate last-minute surprises, confusion, and potential legal disputes.
In an M&A transaction, NWC is typically included in the sale and factored into the agreed-upon purchase price. The NWC Target is agreed upon by both parties before closing and represents the amount of NWC the seller is expected to deliver to the buyer at closing.
How to Calculate the NWC Target
The NWC Target is a crucial element in an M&A transaction, as it can result in adjustments to the purchase price or the final cash consideration for either the seller or the buyer. During financial due diligence, the buyer typically prepares a NWC analysis to establish a methodology for calculating the NWC Target. The seller may also prepare its own NWC analysis in anticipation of the buyer’s negotiations. Ultimately, the NWC Target is a negotiated amount.
There is no one-size-fits-all formula for determining the NWC Target, as each company is unique. However, the goal is to establish a “normalized” NWC Target that provides the buyer with enough working capital to continue operations after the transaction. This normalized level is typically determined by calculating the average NWC over the previous six to twelve months, reflecting the seller’s typical or current state of operations. Using an average over a defined period helps account for seasonality, business cycles, growth or decline, macroeconomic factors, and other timing considerations.
Balance sheet accounts included in the NWC Target calculation can vary, but as most M&A transactions are structured on a “cash-free, debt-free” basis, cash, cash equivalents, and debt-like, interest-bearing liabilities are typically excluded. Below is an illustration of the typical accounts included in a NWC Target calculation:
| Current Assets | Current Liabilities |
| Accounts receivable | Accounts Payable |
| Inventory | Accrued Expenses (i.e., payroll and benefit costs, utilities, rent) |
| Prepaid Expenses |
The Impact of Financial Due Diligence on NWC Targets
Various adjustments are typically made to the unadjusted NWC Target as part of a Quality of Earnings (QOE) analysis. These adjustments help normalize the NWC Target for definitional, diligence, and pro-forma items.
Definitional Adjustments: These adjustments align with the typical cash-free, debt-free transaction structure by removing cash and debt-like items from NWC. Examples include the line of credit, the current portion of long-term debt, and accrued interest.
Diligence Adjustments: These adjustments address non-operating items, non-recurring items, normalization items, or changes in accounting methodology. Examples include:
- Non-operating items: Removal of accrued capital expenditures within accounts payable.
- Non-recurring items: Removal of transaction-related professional fees or personal expenses within accrued expenses.
- Normalization items: Adjustments to account for year-end items not reflected in monthly balance sheet dates.
- Accounting methodology changes: Proposals to accrue for unaccrued vacation or bonuses where they were previously not accounted for.
Pro-Forma Adjustments: These adjustments recast historical NWC on an “as-if” basis, applying current assumptions to retroactively adjust NWC. Examples include the impact of inflation, prior mergers and acquisitions, new products or services, or changes such as eliminating employee positions.
Determining the NWC Target in an M&A transaction is a comprehensive process. Both sellers and buyers should consider company-specific items that may require adjustment to arrive at a fair and reasonable NWC Target.
Other Key Considerations for NWC Adjustments
- Basis of Accounting: Many companies, particularly in the lower middle market, report financials on a cash basis for tax purposes. This would typically not accurately reflect NWC at a specific point in time and may need adjustment to an accrual basis.
- Adjustments to EBITDA: These include one-time, non-recurring, or non-operating expenses accrued on the balance sheet. Common examples are personal or ownership expenses, discretionary spending, one-time consulting fees, and transaction-related costs.
- Timing of Accounting and Bookkeeping: Companies may record transactions at different intervals (i.e., monthly, quarterly, or year-end), depending on their standard processes. If a transaction occurs mid-year, there may be misalignment in the timing of financial records, especially when expenses should be accrued in prior periods.
- Quality of Assets: Common balance sheet accounts like accounts receivable and accounts payable may contain aged items that are uncollectible or unpayable, which could distort NWC if they were not adjusted.
- Related Party Transactions: Transactions between related parties may be non-operational and conducted outside of arm’s length, affecting NWC calculations.
- Unearned Revenue, Cash Received in Advance, and Customer Deposits: If the transaction is structured on a cash-free, debt-free basis, the seller keeps cash on the balance sheet but must pay off identified debt-like items. However, if the company has received payments for goods or services not yet delivered, the buyer will be obligated to fulfill these obligations post-transaction. These amounts may be considered debt-like items, or the seller may need to leave cash in the company to satisfy these obligations.
During a QOE analysis, the QOE provider will typically calculate normalized NWC as of the most recent available month, which could be months before the M&A transaction is completed. The QOE provider will then roll forward the calculation until the closing date. The QOE provider plays a key role in helping both buyer and seller understand the company’s normalized NWC and establish a fair and reasonable NWC Target.
Final Thoughts
Establishing and defining the NWC Target can involve significant negotiations due to the numerous variables involved. When done correctly, the NWC Target should not significantly alter the overall transaction economics to buyer or seller. Given the complexities of NWC and its implications to middle-market M&A transactions, business owners considering a sale should engage experienced M&A advisors to ensure they understand the potential implications of NWC on a future sale.
If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
