Understanding Net Working Capital

Entrepreneurs considering a sale or purchase of a business often ask how assets and liabilities carried on the company’s balance sheet -- including cash, accounts receivable, inventory, security deposits, trade payables, unearned revenue and more -- are incorporated into the sale.

After all, the balance sheet is in constant flux, driven by the sales cycle. If AR shoots up before a sale, if inventory is unusually low, or if the seller takes in deposits before a sale for work to be provided after the sale, what is the impact on the transaction?

The answers to these and other questions stemming from the balance sheet are all usually negotiated in an asset sale via the “net working capital adjustment.” 

When used properly, the net working capital (NWC) adjustment incorporates balance sheet fluctuations into the sale. But to avoid nasty last-minute misunderstandings or surprises, the buyer and seller need to understand and agree how net working capital will be addressed.

Here is a basic explanation of how a NWC adjustment might work. Once you have the basics, it’s easier to understand various complications – which happen in every single transaction. 

First, net working capital is your current assets, minus the current liabilities. Let’s assume hypothetical Company A has a very simple balance sheet with $400,000 in accounts receivable assets; and on the liability side, $50,000 in accounts payable and $50,000 in prepaid revenue. The NWC for Company A is $300,000. 

          $400,000 – ($50,000 + $50,000) = $300,000 

In a very simple asset sale, the buyer may provide a letter of intent that states that in addition to the value of the company, the cash delivered at closing by the buyer to the seller would be increased dollar for dollar for positive net working capital, or decreased dollar for dollar for negative net working capital at closing. For Company A, cash paid to the seller at closing would increase by $300,000. The buyer collects and keeps the AR when it comes in, pays the payables when due, and fulfills the unearned revenue obligation.  

Your balance sheet is clearly not as simple as Company A, but more assets increase NWC, and more liabilities decrease NWC. As the balance sheet fluctuates, the net working capital adjustment fluctuates.

Now, let’s add some complexity:

 Here are three key points to consider as you approach a sale:  

  1. Make sure your balance sheet is accurate before you start the sale process.
  2. Any letter of intent should define how NWC is to be addressed.  Don’t postpone the NWC negotiations until after the letter of intent (LOI) is signed.
  3. The closing documents should include a mechanism for which any changes or discrepancies that come to light after the sale can be handled.  

While it initially can seem confusing, when used correctly, the net working capital adjustment is a clean and simple way to ensure that the position of the company’s balance sheet at closing is incorporated into the value of the transaction.  

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