What Does Working Capital (WC) Mean?
Working capital (WC) is a measure of current assets minus current liabilities on a company's balance sheet. When conducting due diligence on a transaction, historical working capital is analyzed on a monthly basis for two to three years in order to understand the appropriate level a business needs to support its operations.
When cash is excluded from working capital, the resulting amount is called non-cash working capital (NCWC). Fluctuations in NCWC are examined by the buyer to determine what type of additional investment is required to sustain the business. The average NCWC is usually funded using an operating line, but smart buyers will require that a certain level of NCWC be included as part of the deal, since it represents additional cash that the business would require to operate immediately post-transaction.
Divestopedia Explains Working Capital (WC)
The appropriate level of working capital required to sustain business operations is one of the most debated areas between buyers and sellers. Buyers will require that the business deliver a set working capital amount as part of the negotiated purchase price, and the final amount due on closing will be reduced on a dollar for dollar if the peg is missed. Therefore, sellers need to come to the negotiating table ready with an estimated level of working capital that is required to support the business.
Keep in mind that working capital changes every day, so the balance at negotiation must be the estimated amount at closing, rather than the amount reported on the last month's financial statements. Sellers will audit working capital 90 to 120 days post-transaction to make sure the final closing number is accurate. Therefore, it is best to provide the most accurate estimate available including liability accruals which are often missed. Most buyers will include a working capital holdback to allow for any adjustments in working capital post-transaction.
The seller must focus on the following areas when determining an appropriate working capital target:
- Research normal levels of WC for the industry;
- Calculated WC as a percentage of sales year over year;
- Identify special terms that may cause the WC to vary from normal levels; and
- How significantly does inventory vary on a month-to-month basis?