What is net working capital (NWC)?
Net Working Capital (NWC) is a financial metric calculated as the difference between a company’s current assets and current liabilities. In simple terms, it represents the short-term liquidity needed to keep the business running day to day.
- Current assets: accounts receivable, inventory, prepaid expenses, etc.
- Current liabilities: accounts payable, accrued expenses, taxes payable, and similar obligations
Why is NWC important in an acquisition?
Regardless of whether the acquisition is structured as an asset or stock purchase, NWC ensures there is enough capital for the new owners to step in and continue running the company without interruption and without an additional injection of capital after closing. As an example, when you’re buying a car, you expect there to be enough charge in the battery to start the car, power the necessary electrical systems, and get on the highway. Once on the highway, the car’s alternator continues to charge the battery, keeping all the vehicle’s systems operational. Buying a business with negative NWC would be like buying a car with a dead battery. You wouldn’t get very far!
Why doesn’t the seller keep all NWC?
Although sellers generate the working capital, it’s considered part of the company’s value and factored into the purchase price. This would be like having a few spare batteries in the trunk of the car. The seller would remove those batteries before selling you the car so they could keep them.
Is there an alternative way to handle the working assets of the company during an acquisition?
A company can be purchased on a debt-free, cash-free basis.
- Debt-free: The buyer is not taking on the seller’s debt (like bank loans, notes payable, etc.). These liabilities are expected to be paid off by the seller before closing or adjusted in the purchase price.
- Cash-free: The buyer isn’t paying for any excess cash sitting on the company’s balance sheet — that remains with the seller.
So, the purchase price reflects the value of the enterprise itself, independent of how it was financed or how much cash it happens to have on hand at the moment.
What happens to cash and debt in a cash-free, debt-free deal?
The seller retains all excess cash and outstanding debt at the time of closing. Any operational cash present is not transferred to the buyer.
What is reported NWC vs. pro forma NWC?
- Reported NWC: straight from the company’s balance sheet
- Pro forma NWC: the liquidity position of the company after any adjustments are made
What adjustments may be made to reported NWC?
Adjustments are additions or subtractions made to figures used in the calculation of reported NWC, such as:
- Non-GAAP to GAAP adjustments (most commonly cash to accrual)
- Elimination of non-recurring elements of NWC
- Elimination of NWC items related to personal income or non-business-related income or expenses
- Other changes to NWC items determined by changing circumstances between how the company operates pre-transaction vs. post-transaction
What is Target NWC, and How is it Calculated?
Target NWC is the expected pro forma, debt-free, cash-free NWC at closing. It’s usually based on the trailing twelve-month (TTM) average and serves as a benchmark for working capital at close. Target NWC is typically agreed on by both parties earlier in the sale process.
Why is Target NWC used in purchase agreements?
Target NWC protects both parties from sudden operational changes and ensures that any pre-sale business practices do not unfairly affect the buyer’s valuation or financial standing at closing. Without Target NWC, sellers could reduce NWC to pull more cash out, leaving the buyer undercapitalized. It also protects sellers from delivering excess NWC if it wasn’t part of the original deal. Coming back to the car analogy, this would represent the buyer and seller of the car agreeing that the car includes a fully charged battery and will be able to get on the highway.
What is an NWC True-up?
The NWC True-up compares actual NWC at closing to the Target NWC, adjusting the purchase price accordingly. If actual NWC is above the target, purchase price is adjusted up. Conversely, if actual NWC is below the target, the purchase price is adjusted down. A final true-up occurs after closing, solidifying financial reconciliation.
How Does NWC True-Up Differ from an Earn-Out?
- NWC True-up: adjusts for differences in the balance sheet at closing
- Earn-out: adjusts based on future income statement performance post-close
Have more questions about how net working capital impacts your transaction? Contact Ryan Murphy at [email protected] to learn more.