The Importance of the Working Capital Calculation in Mergers and Acquisitions
The working capital adjustment (working capital PEG) in an acquisition is often misunderstood— "Why do I have to potentially pay additional funds to the acquirer, in addition to the agreed upon purchase price in our negotiated Letter of Intent", an owner may ask its advisors.
A working capital adjustment is not meant to be a way for an acquirer to get more funds out of the seller— it’s a protection to ensure a normal historical level of working capital is available for the acquirer to operate the Company post-closing.
The basic definition of ‘net working capital’ is current assets less current liabilities, typically adjusted to remove cash and debt, and normalize for non-operating and non-recurring items.
Most transactions are structured on a ‘cash-free, debt-free’ basis, whereby the seller expects to keep all cash and settle all existing debt through the acquisition proceeds. The below schedule summarizes a reported balance sheet for the purposes of demonstrating the working capital mechanism.
In the above example, cash and debt items were removed from the reported working capital balances as well as income tax payable associated with income based taxes.
It is important to note that operating taxes such as sales tax, franchise tax, and other non-income based taxes should not be removed from the working capital calculation.
Once the initial reported working capital after definitional adjustments has been established, there are many areas within the current assets and current liabilities that need to be strictly analyzed to identify potential other adjustments.
Below we describe typical situations we see in many transactions and the importance in relation to working capital adjustments.
Inventory Obsolescence
At times, a Company may not record an allowance for slow moving or obsolete inventory. Inventory valuation is an important analysis when analyzing adjusted working capital. A buyer wants to verify it is not acquiring bad or non-saleable inventory. The results of this analysis may have little to no effect on EBITDA, but a large effect on working capital.
For example, assuming a Company does not record an allowance for slow moving or obsolete inventory and an analysis indicates that slow moving/obsolete inventory should be $125k as of Dec-22 and as of Dec-23.
This would result in a $0 effect on EBITDA (as the effect of not recording the allowance was the same at each balance sheet end date), but working capital would be overstated by $125k due the reported inventory balance including this obsolete and slow moving inventory.
Conversely, if our analysis indicates that slow moving obsolete inventory should have been $750K as of Dec-22 and $950K as of Dec-23, this will result in a $200K decrease to 2023 EBITDA as demonstrated in the below schedule:
If the Company had properly recorded the slow moving and obsolete inventory reserve as of Dec-22, this would have resulted in $750K more expense recorded in FY22.
If the reserve was updated to $950 as of Dec-23, this would have resulted in an additional $200K of expense necessary for FY23; thereby reducing FY23 EBITDA.
In this example, working capital is also overstated by $750K as of Dec-22 and $950K as of Dec-23 due to these slow moving and obsolete amounts. Further procedures need to be performed to allocate the effects of this overstated inventory through the historical periods for the purpose of the proposed working capital PEG.
Outstanding Checks
If outstanding checks are recorded within cash, then no adjustments to working capital are necessary.
At times, a Company may record outstanding checks within accounts payable. In this instance, outstanding checks should be removed from accounts payable and reflected as a debt-like item.
Customer Deposits and Deferred Revenue
Customer deposits and deferred revenue require special attention when analyzing working capital.
As previously mentioned, transactions are typically conducted on a cash-free debt-free basis whereby the seller keeps all cash at closing. A Company may receive cash in advance for work to be performed in the future or over a period of time. Should the seller be able to keep this cash when a potential buyer will be responsible for fulfilling these obligations? A detailed analysis should be performed to estimate the post-closing obligations and the buyer typically will request that the seller funds the post-closing liability through a debt-like item.
Accrued Bonus
Most companies typically accrue for performance bonuses only at year-end, or record on estimated accrual throughout the year which is adjusted at year-end.
I typically suggest my clients negotiate bonus payments outside of the working capital. A buyer would prefer to be responsible only for bonuses earned post-closing, while the seller funds bonuses under their ownership. I recommend requesting a debt-like reduction to the purchase price related to seller bonus obligations.
Accounts Payable
When analyzing accounts payable, it is important to understand typical payment terms to vendors and compare this to the accounts payable aging. If typical payment terms are 60 days and the accounts payable aging reports a significant amount of accounts past these payment terms, then consideration should be made to reflect out of term payables as debt-like items.
Quality of Earnings Considerations
When proposing adjustments to working capital, it is important to analyze all management proposed and due diligence EBITDA adjustments for working capital considerations. Examples include:
Excess Owners’ Compensation: Amounts recorded in accrued payroll or accrued bonuses for excess owner compensation should be adjusted from NWC.
Transaction Related or Non- Recurring Legal Fees: Accounts payable and accrued expenses should be analyzed for potential liabilities recorded related to transaction related or non-recurring legal fees. Such amounts should be adjusted from NWC.
Loss of Significant Customer: When a Company loses a customer, it typically is not a Quality of Earnings issue as customers can be replaced through ordinary course of business. At times, the loss of a customer may result in the likelihood that it may not be easily replaceable due to its magnitude. A consideration should be made it the margin effect of this customer should be removed from EBITDA. Conversely, any accounts receivable related to such customers would be removed from NWC. Another consideration should be made to adjust inventory on hand for this lost customer if it is not sellable to other customers.
Balance Sheet Metrics
Balance sheet metrics are important when analyzing net working capital including:
Day Sales Outstanding (“DSO”)
DSO measures how long it takes a Company to collect cash from customers. Analyzing this ratio could identify potential aggressive collection efforts pre-closing in attempts to obtain increased cash on the balance sheet.
For example, if a Company historically averages $2MM of accounts receivable on the balance sheet and aggressive collection efforts reduce receivables by $500K, then the buyer can expect to receive less cash in post-closing months.
Days Payable Outstanding (“DPO”)
DPO measures how long a Company takes to pay its vendors. Analyzing these metrics could indicate a Company attempting to slow pay accounts payable in the attempts to pass these obligations to the buyer.
This is a good example of why it is important to analyze accounts payable out of terms for potential debt-like treatment.
Days Inventory Outstanding (“DIO”)
DIO measures how quickly a Company sells its inventory. Analyzing this metric could identify situations where a Company may attempt to unload inventory prior to closing the attempts to increase cash on the balance sheet and also causing the buyer to have to inject capital post-closing to achieve normal levels of inventory.
Closing Working Capital Mechanism
Mergers and acquisition deals structured on a cash-free, debt-free basis typically have a closing working capital mechanism usually based on the trailing twelve-month average of adjusted net working capital.
As the final balance sheet of the target Company is not typically available at close, the purchase price adjustments will be finalized usually 60 to 90 days after closing.
Based on the working capital schedule noted below, the 12-month average of adjusted working capital was $46,822.
Working Capital Adjustments:
Inventory Obsolescence – Removes slow moving and obsolete inventory.
Customer Deposits – Removing customer deposits from the working capital calculation and separately negotiating as a debt like item.
Out of Term Accounts Payable – Remove out of term accounts payable to consider these as debt-like required to be paid by the seller.
Transaction Fees – Non-recurring transaction fees recorded within accrued expense.
Owners Compensation Accrual – Accrual for owner pay that will be considered non-recurring post-transaction.
Assuming this was set as the working capital PEG, the schedule below demonstrates potential post-closing payments between the buyer and seller:
If the adjusted working capital post-closing is calculated to be higher than the agreed upon PEG, then the buyer owes the seller additional funds.
The seller fulfilled its obligation to meet the working capital requirements and is contractually due the amounts exceeding the agreed upon PEG. If the adjusted working capital post-closing is calculated to be lower than the agreed upon PEG, then the seller owes the buyer additional funds as the Company did not meet the agreed upon working capital PEG.
It is extremely important for the terms of the adjusted net working capital to be explained and demonstrated in detail within the purchase agreement. in the attempts to avoid post- closing disputes.
Net working capital components (ins and outs) should be included in a net working capital schedule which are identified by trial balance account number. This should eliminate uncertainty on what should and should not be included in the working capital calculation.
Another important aspect of working capital in the purchase agreement is the description of on what basis the internal financial statements and working capital calculation are based on.
Most companies comply with U.S. Based Generally Accepted Accounting Principles, although there are also typically some deviations as well as working capital accounts that require judgment (i.e., accounts receivable allowance for doubtful accounts and slow moving and obsolete inventory). I suggest the purchase agreement includes the terms that the financial statements were prepared in accordance with GAAP consistent with past practices.
This essentially eliminates some of the uncertainty especially when the terms of how these calculations will be prepared for working capital purposes are agreed upon within the purchase agreement.
Working capital is an extremely important part of any transaction and often causes confusion. It is important buyers and sellers fully understand the importance of the working capital PEG and how it affects the deal.
The greater the detail and clarity around the framework of the adjusted net working capital, the greater the alignment between the buyer and seller resulting in a smoother closing process!
