What is working capital?
Working capital is defined as the current operating assets (such as stock and trade debtors) less current operating liabilities (such as trade creditors, excluding any that are considered cash-like or debt-like, eg cash, bank loans and corporation tax). Working capital is measured over a period of time and the average taken.
Working capital is an important measure of a company’s liquidity. Without sufficient working capital, a business will not be able to meet short-term obligations, including paying suppliers and employees, whose services are required to run the business.
In the context of a transaction, why is working capital important?
For most transactions, there is a purchase price adjustment mechanism regarding working capital. Acquirers want to ensure that they are purchasing a business with sufficient working capital to avoid having to inject a large amount of cash into the business on, or shortly after, completion of the deal.
The buyer also wants to ensure there is no working capital shortage that could impact the business’s ability to trade. To avoid these issues, the buyer needs to establish the business’s ‘normalised’ level of working capital.
The assessment of a ‘normalised’ level of working capital is subjective, with the buyer and seller likely to have differing opinions. Advisers negotiate each of these different standpoints to agree on a level of ‘normalised’ working capital. Every deal is likely to be different, so the method of calculating the ‘normalised’ level of working capital should be agreed at the beginning of the transaction, when terms are being agreed upon in principle.
Many businesses experience fluctuations in working capital over time caused by factors such as seasonality and unusual events and circumstances, for example, a new product launch. In determining the ‘normalised’ level of working capital, adjustments are made to account for such instances.
Once this ‘normalised’ level of working capital has been established, it is crucial to define what happens if this level is not met. Any difference between the ‘normalised’ level of working capital and the actual level of working capital at the date of completion results in the purchase price being adjusted on a pound-for-pound basis. This adjustment can have a significant impact on the price paid for a business, so is a key area of focus during a deal.
Advisers play a critical role in evaluating the working capital dynamics and the negotiations. At Moore Kingston Smith, our specialist transaction services team has decades of experience in supporting clients in this complex area.
For further advice get in touch with our team.