The Crucial Role of Net Working Capital in M&A Transactions

In the intricate world of mergers and acquisitions (M&A), one critical financial factor often overlooked until late in the process is Net Working Capital (NWC). Far from being a simple afterthought, NWC can significantly influence both the purchase price and the successful integration of the acquired company post-transaction. This article breaks down the importance of NWC in M&A transactions, illustrating how it impacts the financial health of the business and the negotiation process.

In its most basic form, NWC is the difference between a company’s current assets and current liabilities, offering a snapshot of its short-term financial health. It is a fundamental metric that measures a company’s ability to meet its near-term obligations.

Particularly in M&A transactions, determining a normalized level for the business’s NWC can be complex and nuanced. Every party involved may have their distinct interpretation of what constitutes NWC. Any discrepancy concerning this number could impact the closing timeline or even affect the final purchase price. Therefore, understanding what NWC includes and how to calculate it becomes crucial for both buyers and sellers.

In most M&A transactions, the standard formula to ascertain NWC in a cash-free, debt-free transaction is: Current Assets (less cash) – Current Liabilities (less debt). However, the process of negotiating the target and actual NWC often becomes a sticking point as different parties may have varying ideas on how to calculate NWC.

The role of NWC extends beyond everyday operations; it plays a significant part in the sale of a business. Prospective buyers, be it a strategic buyer or a private equity firm, will be keen on understanding the business’s financial health. They will want to ensure the company has enough working capital to continue operating successfully after the acquisition closes.

During the acquisition process, the buyer and seller need to agree on a target NWC, typically included in the buyer’s letter of intent. This agreement helps to assure the buyer that the acquired business will be in a healthy financial position to carry on when they take ownership. The target NWC is typically based on a “normalized” level of working capital, taking into account one-time, non-operational factors most relevant and applicable to the business as it exists at that moment.

Arriving at an appropriate target NWC is vital because it could ultimately affect the seller’s proceeds from the sale. If the NWC left in the business at closing is less than the target, the buyer will expect to be compensated for that shortfall. In contrast, if the closing NWC is more than the target, the purchase price will increase.

The process of calculating NWC, negotiating its target, and finally agreeing upon it underscores the importance of professional guidance during M&A transactions. With so many nuances to consider, enlisting expert support can help streamline the process, minimize changes in the final purchase price, and ensure a fair outcome for both buyer and seller.

In conclusion, understanding and accurately calculating Net Working Capital is a critical aspect of any M&A transaction. It serves as a key indicator of a company’s short-term financial health, impacts the negotiation process, and can significantly influence the final purchase price. Businesses planning for an M&A transaction should proactively analyze their NWC with their financial advisors to ensure they are in a strong negotiating position when the time comes.

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About the Author

Ted is a senior manager in our business assurance practice. He specializes in serving clients in the manufacturing and distribution industry and has experience with companies in industries such as business and professional services, technology, and healthcare.

Ted also has significant experience in financial due diligence and transaction advisory services. From buy-side quality of earnings, to sell-side consulting, to post acquisition services, Ted utilizes his experience to help clients identify and minimize risk.

For questions and guidance about these changes, reach out to Ted at ted.smoyer@greerwalker.com or (704) 816-7015.

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