Understanding Net Working Capital Basics

by Michael Schroeder

Learn the basics of how net working capital is calculated so you can better understand how it influences an M&A transaction.

One of the more complex components of an M&A transaction is a seller’s net working capital (NWC). Having a basic understanding of NWC early and knowing how it gets factored into the deal will certainly help alleviate some stress and confusion leading up to a close.

What is net working capital?

In simplistic terms, NWC represents a company’s liquidity or ability to cover short-term obligations and may be defined as “current assets (less cash) minus current liabilities (less debt).” The reason NWC comes into play in M&A transactions is that most businesses are valued based on future cash flows as opposed to an asset value. A valuation of a profitable business based on future cash flows will most often be greater than that of its asset value.

In order for the buyer to be in position to continue to generate those future cash flows without infusing additional cash, they expect to receive a “normal” level of NWC with the business. Positive NWC is used to help fund the operations post-close and additionally serves as collateral on potential financing.

How is net working capital determined?

To determine what a “normal” level is for NWC, an average of the previous six to 12 months is often used, which may be referred to as the “target” or “peg.” At closing, the actual NWC delivered is compared to an agreed-upon target and a “true-up” then occurs. A true-up means that if less NWC is delivered in comparison to the target, a negative adjustment is made to the purchase price and vice versa in the event that more NWC is delivered—then there would be a positive purchase price adjustment. This mechanism is often used in M&A transactions to protect the buyer from a seller eroding its NWC before close for its benefit or on the flip side, using it to provide a benefit to the seller should more NWC be delivered.

Let’s walk through an example

Since most M&A deals are structured as cash-free and debt-free transactions, the NWC definition and calculations often exclude these associated accounts as the “net debt” amount will be satisfied outside of the NWC calculation. The below example incorporates the following components:

  • Six months of actual NWC excluding cash and debt, or net debt
  • An average or target based on the most recent six months
  • An amount of NWC delivered at closing
  • A true-up based on the amount of NWC compared to the target
(000’s) Account Actual 1/31 Actual 2/28 Actual 3/31 Actual 4/30 Actual 5/31 Actual 6/30 Target 6 Mo. Avg. Closing 7/31 True-Up Adjustment
Accounts receivable 1,200 1,180 1,175 1,180 1,165 1,210 1,185 1,225 40
Inventory 600 620 630 615 620 605 615 620 5
Current assets  $1,800 $1,800 $1,805 $1,795 $1,785 $1,815 $1,800 $1,845 $45
Accounts payable 900 880 915 905 910 920 905 925 20
Current liabilities $900 $880 $915 $905 $910 $920 $905 $925 $20 
Net working capital $900 $920 $890 $890 $875 $895 $895 $920 $25

In the example above, the seller would recognize a positive purchase price adjustment of $25,000. While the general concept may be generally understood and would appear easy by way of the above example, this is a topic that is heavily debated and becomes increasingly complex. To ensure you don’t leave any money on the table, it is critical to utilize an experienced M&A advisor to negotiate strategically on your behalf.

For more information or to better understand your options related to transitioning your business, please contact Michael Schroeder, vice president, at ms@taureaugroup.com or any member of the Taureau Group team at 414-465-5555.