Net Working Capital: What is it and How is it Used?
Bill Kenedy, Lutz Consulting and M&A Shareholder
June 18, 2019
A commonly misunderstood topic in M&A transactions is the concept of net working capital (NWC). This is recognized as a predetermined amount of capital that is included in the purchase price in a business sale transaction. Understanding what NWC encompasses and how this amount is calculated is an important step in the M&A process.
What is Net Working Capital?
Net Working Capital is a measure of operating liquidity available to a business at a given point in time. Major NWC accounts include accounts receivables, inventory and accounts payable. In short, it can be calculated as your business’s current assets (less cash) minus its current liabilities. Here is an example calculation for NWC:
Net Working Capital in Business Transactions
In most transactions, NWC stays with the company being acquired as it is considered a necessary operating asset of the business. However, by monthly tracking of collections, payments, and inventory levels, sellers of a business can minimize the amount of money locked up in NWC in order to retain more cash when the business sells.
For example, if the selling company has historically paid its vendors in 15 days even though they have 30 day payment terms, the company could adjust their payment timing to increase cash on hand and reduce NWC. This change would need to occur well before starting an M&A process (more than a year).
The reason for needed to work on your NWC well before embarking on an M&A process is that most buyers will require a NWC peg based on the company’s historical averages.
A problem with relying on historical results is that the information can often be skewed. Seasonality, peaks and troughs, can often affect the validity of a company’s historical results of NWC. To get a more accurate estimate, buyers will establish “trends” by analyzing a company’s historical NWC over a 12-18 month period.
Overall, not understanding and addressing net working capital issues earlier in the M&A process could have a significant impact on the business transaction and the ultimate amount of cash the seller realizes from the transaction. If you have any questions regarding net working capital, please contact Lutz M&A.
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