When a business is considering selling there are many elements to be managed. One of the elements that should be closely monitored is called Net Working Capital (NWC). A unique issue related to NWC is that, if not properly managed in the years leading up to a sale, the seller could end up leaving significant value on the table.
Essentially, NWC is the current assets (inventory, accounts receivable, prepaid expenses) of a company in excess of the current liabilities (trade payables, accrued wages, etc.). Within a specific transaction, items normally included in this definition may be specifically excluded from the definition agreed to by the parties. Some of the common exclusions include cash, refundable tax payments, or related party receivables and/or payables. Since NWC is what allows a company to operate day to day, a buyer wants to make sure that there is sufficient NWC to allow the company to operate in the days immediately following a transaction. To accomplish this the buyer will generally set a target for the NWC. The agreements will require the buyer to pay for any excess NWC and require that the seller make up any NWC shortfall. This prevents sellers from altering the value of a company by driving down receivables, or letting payables build up, in the days leading up to a transaction.
With this background in mind, managing NWC maximizes proceeds on a sale, NWC should be maintained at as low of a level as feasible to operate the business. Some of the items to consider include:
- Is the company carrying excess inventory?
- Is the company prepaying expenses that don’t need to be prepaid?
- Is the company paying payables significantly ahead of their due date?
- Is the company fully accruing expenses at the end of a period?
Importantly, when a purchaser conducts their due diligence, it is common to look at the NWC amounts over a trailing 12 to 18 month period, and set a target for NWC based on an average of that period. This reinforces why it is important to manage the NWC of a business, well before a transaction is expected to occur. Recognizing that it takes time to true up prepaid amounts and book accruals on a monthly basis, it becomes key as a business is approaching a transaction to assure that these adjustments are made accurately on a monthly basis.
In the process of managing NWC prior to a transaction, it may become evident that there are valid reasons for a company to carry excess NWC. For example:
- Excess inventory may be carried due to significant quantity discounts to be obtained or there may be certain inventory that is scarce
- Accounts payable may be lower than customary to take advantage of early payment discounts.
In these situations it is important to be able to articulate to a buyer so that the proper NWC targets are set. Contact us if you need assistance in determining or computing a normalized NWC for your industry.