In simplest terms, working capital is the difference between current assets and current liabilities that are recorded on a company’s balance sheet. It provides an indication of the short-term solvency of the enterprise and includes assets such as cash, accounts receivable, inventory and prepaid assets also known as operating current assets. Alternatively, enterprises also record accounts payable, accrued liabilities, deferred revenue, taxes payable and short-term debt as current liabilities.
Now, let us talk about what occurs with working capital in a transaction and furthermore, let us assume the structure of the transaction is an asset purchase. Under an asset purchase assumption, an analysis of the historical working capital leads to a negotiated level of working capital the seller will deliver to the buyer at closing. In smaller deals, the seller keeps all the cash and delivers the remaining working capital to the buyer, while the opposite is true as enterprise values begin to increase. In some cases, the seller retains the accounts receivable under the theory that this is earned services and only the passage of time is the reason this asset is not converted into cash. One additional point, in an asset deal, all existing debt, whether it is a revolver or term-debt, remains with the seller.
Lastly, I want to provide an example of how working capital can affect the transaction price. Let us assume the buyer will pay $10 million for the assets of the enterprise at closing, and as a part of the assets, the seller will deliver $500,000 in working capital.
Purchase Price: $10,000,000
Negotiated Working Capital: $500,000
Mechanically, if the seller delivers $400,000 in working capital to the buyer instead of $500,000, then the purchase price is adjusted downward by $100,000 for the shortfall in working capital [$10,000,000-($500,000-$400,000)]. Alternatively, if the facts are reversed, then the purchase price is increased by $100,000 because of the excess working capital delivered to the buyer [$10,000,000-($500,000-$600,000)]. The last equation is a little confusing because it states to subtract a negative number, but I wanted to maintain consistency in the location of the constants and variable between both equations.
Increase/Decrease in Purchase Price Formula
Increase/Decrease in Purchase Price = Purchase Price – (Contracted Working Capital – Actual Working Capital)
Finally, it is possible to flush out working capital issues in a sell-side due diligence project. This type of engagement analyzes existing working capital of the selling company before the company goes to market. Of course, the buyer will do their own due diligence around working capital, but it is nice to know where the warts are before the buyer locates them.
Mike Metzler CPA/ABV, CMA, CGMA, ASA