Net Working Capital: What To Know When Involved in an Acquisition
Net Working Capital: What To Know When Involved in an Acquisition
Today’s macroeconomic and geopolitical landscape presents many factors for deal makers to consider when trying to evaluate an acquisition. Inflationary pressures, supply chain disruption, labor shortages, war in Ukraine, and government shutdowns all create commercial, operational, and financial challenges. While the profitability and cash flow impact of these challenges may be addressed in a quality-of-earnings analysis, it is critical to ensure the current and future impacts of these challenges are addressed when assessing the “normal” level of working capital for purposes of setting the peg at closing and, ultimately, understanding what is required to operate the business.
Creative solutions such as working capital “collars” or adjustment caps can be applied to mitigate large working capital adjustments at closing, particularly when there is a heightened level of uncertainty; however, thorough due diligence should be performed to understand drivers, volatility, and requirements going forward.
The Importance of Net Working Capital
Net working capital (NWC) represents the money available to fund short-term operational obligations. It impacts many areas of the business, such as settling with vendors, securing inventory, and meeting payroll. Working capital can fluctuate significantly throughout the year due to seasonality, changes in customer demand, availability of supply, pricing, and unplanned events.
When considering an acquisition, working capital is typically a component of the purchase price with a dollar-for-dollar adjustment mechanism to settle the delta between the agreed-upon working capital target (or “peg”) and the amount as of the closing date. While traditionally NWC is defined as current assets less current liabilities, it is generally more complex in a transaction, as it could include several adjustments. Examples include:
- Definitional adjustments: This could include adjustments consistent with a cash-free/debt-free transaction (e.g. cash, income taxes, and financing-related items)
- Diligence adjustments: This could relate to non-operating or non-recurring items, changes in accounting methodology, or other types of normalization items
- Pro-forma adjustments: This is recasting the historical NWC balances on an “as-if” basis by applying more current or relevant assumptions (e.g., retroactively adjusting NWC components for increases in pricing due to inflation)
Therefore, it is critical to understand the components of working capital and drivers of fluctuations to make sure the business has the levels it needs on day one without any disruptions or need for cash infusions. This is also critical to ensure the appropriate peg is established at closing with appropriate documentation included in the sale and purchase agreement to minimize post-closing adjustments and disputes.
What to Consider When Evaluating NWC
When evaluating NWC, the devil is in the details. Adjustments to determine the required level of NWC for the business and establishing the appropriate peg is typically not identifiable at a balance sheet summary level. Summary level accounts may include non-operating items or mask unusual trends in the business.
NWC components should be assessed at a detailed level (e.g., trial balance and sub-ledger) to ensure each account is considered, and, if necessary, adjusted when evaluating normalized NWC and determining the peg. Items excluded from NWC should be further assessed for debt-like treatment in the sale and purchase agreement.
Quality of assets and completeness of liabilities
The acquisition target’s accounting policies and procedures may not include a robust monthly closing (“hard-close”) process, resulting in the potential misstatement of account balances at a given month-end. This tends to be more common with accounts requiring a higher level of subjectivity (e.g., bad debt or inventory reserves and accrued liabilities).
One should inquire with management as to the frequency of a hard-close accounting process to identify accounts that may require further analysis to assess the quality and completeness and may require adjustments for purposes of estimating the normalized NWC. This may include the following:
- Review the company’s accounting and reporting manual to identify month vs. quarter vs. year-end differences, if available
- Review of accounts receivable and inventory aging to identify uncollectible accounts or obsolete inventory and adjust reserves accordingly
- Review of accrued liability account reconciliations to assess reasonableness of estimates and methodology
Notably, NWC requirements can shift significantly across periods for a variety of reasons:
- Seasonality: Businesses subject to seasonality can experience significant month-to-month fluctuations due to seasonal timing of sales and purchasing patterns.
- Business expansion / contraction: Growth or decline in the business can result in changes to NWC requirements (such as large customer wins or losses, new or discontinued products, and geographic expansion or contraction).
- Macroeconomic factors: Inflation and rising prices impact nearly every component of NWC, which can result in higher run-rates going forward. Supply chain disruption can also have impacts. Shipping lead times, scarcity of raw materials, the war in Ukraine, and government shutdowns have all contributed to companies needing to reassess and reconfigure their supply chains. This has led to increased costs and changes in buying patterns to secure product, all which impact NWC.
Establishing the Net Working Capital Peg Is More of an Art Than a Science
When establishing the NWC peg, the drivers, their recurrence, timing, and impact need to be assessed to ensure the right approach is taken. Best practices when performing this assessment include:
- Understand the recent changes in the business and how these impact NWC in the present and going forward. More recent NWC trends may be more indicative of normalized levels going forward.
- Calculate and analyze key NWC metrics, such as days sales outstanding, day inventory on hand, and days payable outstanding (DSO, DIOH, and DPO, respectively). These metrics can help identify problems and opportunities with the business’ working capital management and help understand the timing of the business’ cash flow cycle. These metrics can also be applied to the forecast of the business to understand future NWC needs when there is an expected growth or decline in the future (e.g., geographical expansion or contraction, plant openings, or closings).
- Review the financial statements as a whole. The income statement and balance sheet are linked and should be reviewed collectively to ensure the valuation of the business is comprehensive and aligned.
Defining Closing Net Working Capital in the Sale and Purchase Agreement
To avoid surprises and mitigate manipulation, it is best practice to include a tight definition documenting in detail how closing NWC will be calculated. From a buyer’s perspective, this provides protection so the seller can’t increase cash or decrease debt through the manipulation of NWC (e.g., accelerating collections, delayed payments to lenders).
When documenting a tight definition, it should explicitly address the accounts included and the accounting principles to be applied when calculating closing NWC.
Accounts included can be an exhibit in the sale and purchase agreement, which provides an illustrative calculation of NWC at a trial balance level (TB) with account numbers. This should align with how the peg was established along with adjustments, if any, to be included in the true-up mechanism. Accounting principles refer to the methodology being applied to the included accounts when calculating closing NWC. This could include 1) specific principles, policies, or procedures to be applied, 2) establishing consistency with a set of financial statements, or 3) defaulting to GAAP if not covered by the previous two options.
Including these elements in the definition should mitigate ambiguity of how closing NWC should be calculated and reduce the likelihood of a dispute.
As previously noted, a dollar-for-dollar adjustment mechanism to settle the delta between the agreed-upon working capital target (or “peg”) and the amount as of the closing date is documented in the sale and purchase agreement. If well documented, disputes can be mitigated, but if not, the adjustment can be significant and ultimately lead to disputes between the buyer and seller. Drivers of such adjustments could include the following:
- Lack of a tight definition, thereby allowing parties to manipulate NWC
- Inadequate diligence performed when establishing the peg
- Seasonality in the business
- Growth or decline in the business
- Closing on a non-month end date (e.g., mid-month) where a “hard-close” accounting process is not performed, and assumptions are required
- Unplanned events
To avoid unplanned large adjustments or surprises, an estimate of closing NWC is typically prepared around five days prior to closing. While this is an estimate, it should be prepared based on applying the definition of closing NWC and the accounting principles as documented in the sale and purchase agreement. The estimate can be reviewed by both buyer and seller ahead of closing to resolve any discrepancies and update the estimate or sale and purchase agreement as necessary.
There are various creative approaches that can be taken when defining the adjustment mechanism. However, these may serve in the interest of only one party, and the ability to obtain such an approach is typically tied to the negotiating power and deal acumen of each party. When applied, these items should be specifically documented in the sale and purchase agreement. Examples include:
- NWC “collar”: This is an approach used to avoid adjustments for differences between the peg and closing NWC. If the difference between the peg and closing NWC is within the negotiated collar amount, then no adjustment is made. If the delta is outside the collar, then all or just the incremental delta could be subject to the mechanism (depending on what is negotiated).
- “One-direction collar”: If the buyer is concerned the seller will manipulate NWC leading up to closing, they may seek a “one-direction” collar whereby an adjustment is only made to the extent closing NWC is lower than the peg (in favor of the buyer).
- NWC cap: To avoid large adjustments or settlements, buyers and sellers may cap the adjustment to be no greater than a certain dollar amount, whether positive or negative.
Perform the Right Level of Due Diligence
In summary, there are many elements to consider when assessing the “normal” level of working capital for purposes of setting the peg at closing and understanding what is required to operate the business. Recent macroeconomic events have disrupted businesses and the net working capital requirements needed to operate.
Therefore, it is critical to perform the right level of due diligence to ensure NWC requirements are understood and the right protections are included in the sale and purchase agreement to mitigate surprises at closing and going forward.