Net working capital (commonly referred to as NWC) is a very vital part of any business transaction and can be described as a representation of how healthy your business is in the short term. This figure shows to a buyer how liquid your business is, and how efficiently it can meet its debts and obligations; these usually come in the form of accounts payable. It is also a measure of how your business handles its invoices and inventory, which are usually recorded as accounts receivable, or assets. When closing on the transition of a business from seller to buyer, a huge mistake often made by the seller is either not fully understanding NWC or not knowing its importance, leaving them to scramble in the middle of negotiations which can cause a deal to fall apart fast. To prevent these detrimental events from transpiring, take a closer look at how working capital functions, how important it is to your business, and the steps involved in making it work for you rather than against it in a close.
Formulaic Functionality
Let us first look at how working capital is calculated since it can be different for every business. Put simply, NWC is your accounts receivable and current assets plus inventory minus your accounts payable plus current liabilities. The process involved in finding your working capital can vary greatly from business to business, and there are a few reasons why. The model of a business largely affects NWC, as it can be negative or positive depending on how that business, well, does business. When dealing with working capital, it is important to understand that changes in this affect the cash flow within a company. For example, a negative working capital, or when current liabilities are higher than the number of current assets, is not necessarily a bad thing in the short run. Negative working capital can show that a business prioritizes taking in cash from customers as fast as possible and paying out to suppliers as slowly as possible. By doing this, that business can raise its cash flow exponentially and ensure a period of manageable growth.
This model usually involves a business with subscription-based revenue and a high inventory turnover rate in which they get paid before or soon after services are rendered; this style helps keep as little as possible out of accounts receivable and put more into their pockets to quickly pay short-term debts. On the other hand, a positive working capital, meaning your current assets are of greater quantity than current liabilities, is usually preferred when a business’ inventory turnover rate is much slower and it cannot generate cash as quickly; this situation calls for higher, positive working capital. Businesses with a positive working capital make more use of the credit in their accounts receivable and payable, meaning terms are set between suppliers and customers regarding when payment will be made. The goal when using the latter business model is to use the excess assets found in a positive NWC for promoting that same level of company growth; be careful not to entertain a positively increasing working capital over time, since this implies that extra assets are not being properly used for expansion. It is the same with a constant or declining negative, as this can show that cash flow has declined with your NWC, which could lead to liquid bankruptcy and certainly a disapproving glance from any buyer. It is your job as the owner to know your business model and what ratio of working capital works for you.
Why It Matters
Now that you know the basics of how NWC functions, there are several reasons for it being such a dire factor in a close. Any buyer you enter negotiations with will be looking at this figure closely to set a working capital peg or the amount of working capital they require be left in the business after transitioning. A buyer does this to ensure they will not have to pour money into your business after a transaction; in other words, they want to make sure your business is self-sustaining. A misunderstanding of working capital and asset neglect can lead to sellers taking too much out of their business so they can keep more in their pockets. This is never a good idea, as your buyer will certainly notice; paying full price for half or three-quarters of a company makes no sense. The most efficient way to avoid any confusion between parties is to, as the owner of your business, calculate and understand your net working capital and refer to it in the letter of intent. Doing this will spare you from a heavy negotiation process near the finish line of the deal, which is usually where working capital targets are disputed the most. Letting a buyer do it for you will leave you open to being undercut in price, which is never ideal. Being well-versed in how your business uses working capital grants you the ability to achieve a high selling price while leaving a happy minimum for your buyer.
Understanding the Change
Every business has its ups and downs throughout the year, and working capital can change largely based on seasonality. Due to this, there is no set formula for every business regarding calculating its NWC. Perhaps the most popular and efficient method is to take working capital requirements for each month in a year and produce the average; this is the fairest way to present the figure to a buyer. If a business happens to be seasonal, the owner may try to present a working capital based only on high-selling periods to boost selling value. Due to this being a possibility, buyers will typically require a month-by-month full-year capital report to gain a more realistic view of what operational costs are like outside of those periods. The average taken from this analysis will affect the working capital peg given, and it is up to you as the seller to negotiate a fair target and meet it to the best of your ability. Current working capital will be calculated on the day you sign the papers, and this infers a few important details. If you fail to meet the peg set by you and the buyer, whatever that final difference is will be taken from the agreed-upon closing price, AKA your own pockets, since that money would have been yours if requirements had been met. Similarly, if your closing working capital exceeds the peg, the buyer will usually pay the difference because your company rose in value. Knowing how working capital changes affect your business's value is crucial, as it can negatively or positively make a difference in a transaction.
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