By Roman Basi—Whether you are a company like Amazon or a small, locally owned business, business owners need to understand the importance of working capital. This simply means a company’s available capital for daily operations at any given point in time. It can provide measurements to determine a company’s operational efficiency and short-term financial health.
The basis of working capital is the calculation: the amount of a company’s current assets minus the number of its current liabilities. To be considered a current asset, they must be an asset that can be converted into cash within one year or less. Some examples of this would be cash equivalents, accounts receivable, inventory and pre-paid expenses.
Current liabilities, by comparison, can include short-term debt such as accounts payable, accrued liabilities and other similar types of debt. When you subtract your current liabilities from your current assets, you will be provided with the working capital figure. The figure will be positive when there are excess current assets compared to the current liabilities. While working capital plays a role as a financial measuring tool, it also plays a large role in mergers and acquisition (M&A) transactions.
While the calculation may be simplistic, there are some differences when it comes to an M&A transaction. The calculation can become more complex as the formula will be dictated by the asset or stock purchase agreements. Some transactions may involve cash or debt in the calculation, while other transactions may exclude certain assets or certain liabilities—which then creates an impact on the seller that can vary on a spectrum. This spectrum will generally be determined within the purchase price or working capital section of the stock or asset purchase agreement. Whenever the determination is made, a target will be set. This means that the operations of the selling company before the target date can have a drastic impact on the closing funds.
To put into perspective, for example, the language of an asset purchase agreement may state, “a purchase price of $6 million minus the amount by which the working capital as of the closing date varies from the six-month trailing average of the working capital.” The calculation methodology used will then be described in the asset purchase agreement.
Therefore, a target is set by a 12-month average trailing the closing date of the transaction. If, when at closing, it exceeds the average monthly working capital balance for the 12 months before the closing, the seller will generally walk away with more funds upon closing. However, if at closing it is less than the average monthly balance for the six months before closing, then the purchase price may be reduced by the amount equal to the difference of the 12-month average.
Working capital is a key component when it comes to analyzing the efficiency of a company. When a company has positive working capital, they are typically in good shape for expansion or at least maintaining its current course. Keep in mind, some businesses operate with negative working capital just from their nature of business. (These include inventory-based businesses). Being able to know the importance of this and how it affects the business you are evaluating can help determine the viability of the business.
Roman Basi is an attorney and CPA with the firm Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. He co-authored the article with Ian Perry, staff accountant.