Working Capital – What Is It and Why Is It Important?

Working Capital is an important concept for every business to understand. From Amazon or Apple to a small locally owned business, business owners need to understand the importance of working capital. At its heart, working capital is defined as, “the amount of a company’s current assets minus the amount of its current liabilities,” or simply, a company’s available capital for daily operations at any given point in time. Thus, working capital provides a measurement to determine a company’s operational efficiency and short-term financial health.

At the basis of working capital is the calculation, which is generally the difference between the current assets and the current liabilities. Current assets are assets that can be converted into cash within one year or less. This would include assets such as cash equivalents, marketable securities, accounts receivable, inventory, and prepaid expenses. While current liabilities include short term debt such as accounts payables, accrued liabilities, and other similar debts.  Subtracting the current assets by the current liabilities will provide the working capital figure. The working capital is positive when there is an excess of current assets compared to current liabilities.
However, a working capital calculation not only plays a role as a financial measuring tool, but it can play a large role in Merger and Acquisition (M&A) transactions.

As stated above, a working capital calculation is generally calculated as current assets less current liabilities. However, the calculation of working capital in an M&A transaction can be far different as the formula will be dictated by the asset or stock purchase agreements. Some transactions will involve cash or debt in the working capital calculation, some transactions may exclude certain assets, and some transactions may exclude certain liabilities, thus creating an impact on the Seller that can vary on a spectrum. The spectrum will generally be determined in the Purchase Price or Working Capital section of the stock or asset purchase agreement. When
the working capital determination is made a target will be set and the operations of the selling company prior to the target date can have a drastic impact on the closing funds.

For example, the working capital language of an asset purchase agreement may state, “a purchase price of $5,000,000 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 asset purchase agreement will then go on to describe the calculation methodology of the Working Capital.  Therefore, a working capital target is set by a six month average trailing the closing date of the transaction.

A Working Capital section of a stock or asset purchase agreement will typically have language similar to the following, “At the Closing, the Purchase Price shall be subject to adjustment in accordance with paragraph (b) below, based on an amount (the “Estimated Closing Net Working Capital”) equal to the Companies’ good faith calculation of the estimated Net Working Capital of the Business as of the Closing Date (the “Calculation Date”).” This statement will likely be followed by another which says, “If the Estimated Closing Net Working Capital is less than $[●](“Net Working Capital Target”), the Purchase Price payable at the Closing shall be reduced by an
amount equal to such deficiency (such deficiency to reduce the Initial Cash Purchase Payment payable to the Companies at Closing).”

The purpose of these clauses in asset purchase agreements is to ensure the buyer and seller are both getting their due pricing. Imagine buying a company, which initially shows solid working capital, but upon looking at the averages over time it shows a steep decline. This may indicate you are buying a company which is hemorrhaging money, or being run incorrectly. By requiring an adjustment of the purchase price based upon average working capital can ensure both parties are protected in the transaction.

To sum up, working capital is a key component to analyzing the efficiency of a company.  A company with positive is typically in good shape for expansion or at least maintaining the current course; however, it is important to remember that some businesses operate with a negative working capital just from their nature of business (think inventory based). Knowing how working capital effects the business you’re evaluating can help determine the viability of the business.  While the basic formula for working capital is simple, actually applying it to the company can be difficult. If you are in need of a business valuation through working capital, or have questions about your own business contact us at the Center for Financial, Legal & Tax, Inc.

Share this post:

Comments on "Working Capital – What Is It and Why Is It Important?"

Comments 0-5 of 0

Please login to comment