One might think that calculating net working capital is a relatively simple exercise — current assets less current liabilities. However, this simple exercise can turn into a very complicated calculation during a transaction process. At a time when both buyers and sellers just want to move on, they instead face potential arbitration or litigation post-close that could have been avoided overall.
To avoid additional costs and strained relationships, buyers and sellers should take care to avoid common mistakes that can be divided into 3 categories: When Setting the Target, When Drafting Legal Documents, and After the Close.
Today’s focus is When Setting the Target
The following items are often large influencers in the calculation of net working capital (NWC):
- Not considering seasonality
If the business is highly seasonal and the closing is not occurring during the peak season, using a trailing 12-month average to calculate a target might be misleading. Seasonal businesses (e.g., ski resorts, holiday retailers, hospitality businesses, etc.) have peaks and valleys to their revenue and, as a result, to their working capital. If a transaction is closing during a downturn, the trailing 12-month average of NWC might overstate the target and might not be the best indicator for working capital as of the close date. Other mechanisms of calculating the working capital such as looking at ratios to revenues or expenses at the same periods should be considered in these circumstances.
- Not taking changes in operations into account
Overlooking what might seem like minor changes or disruptions in your operations can also affect your working capital calculations. Maybe your accounts receivable clerk was out for a period of time and you got behind on collecting receivables. Or maybe last year you stocked up on inventory due to known pricing increases. If this is the case, using historical figures might overstate or understate the working capital target. External factors, such as customers paying more quickly or slowly as a result of their own circumstances, can also influence working capital. Consideration for these dynamics should be given when there are significant recent operating changes that affect NWC.
- Not including normalizing or year-end-only adjustments into working capital
If adjustments are made during quality of earnings assessments or year-end audits, more than likely there are adjustments that need to be made in setting the target NWC. Also, if the seller normally accrues payroll, bonuses, etc. only at year-end, average NWC can be significantly understated. These accruals should be reflected throughout the monthly balance sheets to properly calculate a target.
- Not looking at off-balance-sheet liabilities
Debt that is not on the balance sheet is often a cause for debate since some companies don’t record all their liabilities on the balance sheet. This could include large unfunded pensions or reclamation liabilities (like asset retirement obligations (AROs). Unknown large off-balance-sheet liabilities can put the buyer at risk and can negatively impact the transaction.
Check back for Part 2 of this series – Avoid These Mistakes When Calculating Working Capital – When Drafting Legal Documents
If you have any questions, feel free to contact Joan Young, President of Sunbelt Business Brokers, Greater Bay Area – [email protected]. Sunbelt also handles Mergers and Acquisitions.