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, and war in Ukraine 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, current and future impacts of these challenges must be 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.

What Is Net Working Capital and Why Does It Matter

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.

Performing Due Diligence on 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. 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.

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.

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.
• 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 and scarcity of raw materials 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.

What to Consider When Establishing the Peg

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.
• 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.
• Review the financial statements as a whole. The income statement and balance sheet are linked and should be reviewed collectively.

Sale and Purchase Agreement Considerations

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. Including these elements in the definition should mitigate ambiguity of how closing NWC should be calculated and reduce the likelihood of a dispute.

Adjustment Mechanism

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.

To avoid unplanned large adjustments or surprises, an estimate of closing NWC is typically prepared prior to closing. It should be prepared based on applying the definition of closing NWC and the accounting principles documented in the sale and purchase agreement. The estimate can be reviewed by both buyer and seller ahead of closing to address and resolve any discrepancies.

There are various creative approaches that can be taken when defining the adjustment mechanism, such as adjustment collars (e.g., no adjustment is made if within the negotiated collar amount) or caps (e.g., adjustments can be no greater than a certain dollar amount). 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.

Be Thorough in Your Due Diligence

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.