When negotiating a deal, the net working capital position of the company being acquired is a hotly debated topic. As net working capital directly affects the price paid by the buyer, objectives on both sides of the table may differ, making it a crucial area for clear and considered discussion.
Net working capital is a metric indicating a company’s ability to cover the costs of day-to-day trading (e.g. payroll, utilities, rent) with cash generated by the business, and in its simplest formula:
Current assets - Current liabilities = Net working capital
The overall health and liquidity of a business is measured by net working capital. If current assets are greater than current liabilities, this means the company can meet its short-term obligations. In a wider sense, the metric also indicates whether a company’s current business practices – such as inventory management, revenue collection from customers and payments to suppliers – allow that company to generate more cash than it uses up.
Net working capital is an important element of any deal negotiation, as buyers want to be assured that they won’t have to fill in any gaps to cover short-term cash shortfalls immediately after acquiring a company. Buyers will also typically pay £1 for £1 for any cash held by the business in excess of short-term funding requirements (see my previous blog on cash-free, debt-free transactions for more detail). As part of the due diligence process and the negotiation of the sale and purchase agreement, sellers will need to supply detailed information to the buyer confirming their net working capital and cash position.
When identifying items to include in the net working capital calculation, the question sellers must ask is whether the item is a recurrent one that is part of the company’s normal operational activities.
Common examples include:
- Trade receivables (debtors): cash due in from customers from sales of products or services that hasn’t yet been received
- Inventory: product stock held by the company, work in progress, raw materials, finished goods on hand
- Prepayments: cash paid for expenses not yet due (e.g. rent paid monthly in advance)
- Accrued income / revenue: products or services that have been sold to a customer but an invoice has not yet been raised to ask for payment
- Other receivables: cash due to the company for non-trade reasons such as income tax receivable, insurance claims receivable or amounts due from employees
In an M&A context, it is important to note that the calculation of net working capital excludes cash (as classified under current assets on a company’s balance sheet), since this is considered separately in the calculation of net debt.
- Trade payables (creditors): cash owed to suppliers, which hasn’t yet been paid
- Short-term borrowings: overdrafts, credit card payments
- Accrued expenses: cash expected to be paid for an expense that isn’t yet due for payment but is expected to be incurred by the company (e.g. bonus payments, outstanding invoices from suppliers)
- Wages payable: cash amounts owed to employees but not yet paid
- Taxes payable: cash owed to HMRC or other tax authorities but not yet paid (eg. VAT, corporation tax is typically considered debt)
- Interest payable: cash due as a result of institutional loans or other borrowings
- Provisions: cash which might be held in reserve relating to a business incident such as repairs required for the company’s offices or a customer not able to pay for goods or services
- Warranty or customer claims: cash owed to customers or other parties due to a reported issue (e.g. financial compensation for a complaint or replacement for a damaged product)
- Deferred income / revenue: cash received in advance from customers but the product or service has not yet been provided by the company
- Customer rebates or discounts: benefits due to customers as part of the normal course of business (often excluded from net working capital if one-off in nature)
These examples are not exhaustive. It is common for buyers to argue that certain liabilities should be classed as part of the net debt calculation instead of as part of net working capital, the result of which would be a reduction in the price paid by the buyer. Each item is considered on a case-by-case basis.
The total of current liabilities is deducted from the total of current assets to calculate net working capital, consistent with the formula above.
As the value of each of these items changes daily for most companies, the sale and purchase agreement will specify a ‘target’ net working capital, which equates to the normal level of net working capital for the company over a period.
Most commonly the target net working capital is calculated by averaging the last 6 or 12 months of historic current assets and current liabilities to level out any seasonality or fluctuations which may occur from one month to the next during the company’s recent past. Another method of calculating the target may be to take an average of the last 6 months’ historic data and look ahead 6 months in the forecast period to find a “normal” level. This alternative method can be beneficial if, for example, a company is scaling revenues quickly but with minimal costs of customer acquisition.
Both the buyer and seller will need to agree on the target net working capital, which in FirstCapital’s experience is always a point of contention when negotiating a deal as it will affect the amount of cash due to the sellers on completion. For example, if the company’s target net working capital is negative (i.e. more liabilities than assets), the buyer will be exposed to any shortfalls post-acquisition. This negative target will then be deducted from the headline price when calculating take-home proceeds.
We recommend that this calculation is prepared and that sellers identify ‘normalisation’ adjustments as early as possible in our SMART dealmaking process to be in a strong position for negotiation.
Read my next Demystifying M&A blog for insight on calculating net debt and how cash features in a transaction