Understanding working capital adjustment in business acquisition: a comprehensive guide

Introduction of Working Capital Adjustment:

Let’s consider a scenario where a business acquisition is underway with an agreed purchase enterprise value of £2 million, assuming a target working capital of £500,000. Now, if at the time of closing the deal, the actual working capital is £300,000, should the buyer still pay £2 million? The answer is no. Similarly, if the actual working capital is £700,000, should the seller still receive £2 million? Again, the answer is no. Therefore, to ensure the buyer pays and the seller receives the correct consideration, we need to understand what’s called "working capital adjustment."

When acquiring a business, one of the critical components that often requires careful consideration and gets missed is the working capital adjustment. Working capital, which represents the operational liquidity of a company, plays a vital role in ensuring the smooth functioning of day-to-day operations. Therefore, understanding how to effectively manage and adjust working capital during the acquisition process is essential for both the buyer and the seller. In this blog post, we’ll delve into the intricacies of working capital adjustment in business acquisition using an example to justify its significance, key considerations and how can the buyer justify the acquisition price to the seller while also considering the seller’s perspective and ensuring fairness and transparency throughout the negotiation process.

What is working capital adjustment?

Working capital is calculated as the difference between a company’s current assets and current liabilities. It reflects a company’s ability to meet its short-term obligations and fund its day-to-day operations. While negotiating a purchase/sell price for the business, the buyer and seller must agree on the appropriate level of working capital to be included in the purchase price, that ensures smooth operations of business in coming months after the acquisition.

Working capital adjustment means making sure that the company has enough liquidity for everyday expenses that matches with what was agreed upon when buying the company. If the liquidity is not at the agreed upon level, the purchase consideration will be changed to reflect this. This means adjusting the enterprise value of £2 million, for the deficit/surplus of £200,000 in working capital in the example above.

Also See: How to buy a business and ideas to expand your new venture

How it actually works in a Business Acquisition?

Situation 1: If the working capital (WC) is below the target level, the buyer will need to decrease the purchase price and provide extra money to boost the WC to the target level. This means the buyer pays the same overall price, but the sellers receive less money. For instance, if the selling company has £300,000 in WC instead of the target £500,000, the buyer will reduce the enterprise value (EV) accordingly, affecting the equity value (net of debt and cash).

Situation 2: Conversely, if the WC exceeds the target, the buyer will raise the purchase price and retain some of the surplus WC after the deal closes. In this case, the buyer still pays the same total amount, but the sellers receive more. For instance, if the WC is higher, say £700,000 instead of £500,000, the equity value increases accordingly. This means the buyer will pay more upfront and might recoup some of it in form of the excess WC post-acquisition.

Key Takeaway:The buyer’s equity remains the same in both situations, but the seller’s equity value changes. This shift of risks encourages sellers to maintain adequate working capital before the deal closes.

Also See: Considering Debt? A Guide for Businesses

Importance of Working Capital Adjustment:

Accurate Valuation: Working capital adjustment helps in accurately valuing the target company by considering its financial health at the time of closing the deal. It ensures that the purchase price reflects the true value of the business’s operational assets and liabilities.

Mitigating Risks: Failure to properly adjust working capital can result in financial discrepancies between the buyer and seller post-acquisition. By conducting a thorough working capital adjustment, both parties can mitigate the risk of future disputes related to the transaction.

Aligning Interests: Working capital adjustment aligns the interests of the buyer and seller by ensuring that the purchase price is based on the actual financial condition of the target company. It promotes transparency and fairness in the acquisition process.

Reduces malpractices: Taking into account the actual vs the target working capital in the business, the motive of seller to not pay the bills on time goes out of the picture.

Key Considerations in Working Capital Adjustment:

Define Working Capital Components: Clearly define the components included in the calculation of working capital, such as accounts receivable, inventory, accounts payable, and accrued expenses. Consistency in defining these components helps avoid misunderstandings during the adjustment process. Cash is usually excluded.

Number of debtor/creditor days: We must consider the time gap between receiving and paying money. While working capital includes accounts receivable and accounts payable, it overlooks the time it takes to receive or pay these funds. Therefore, we should adjust the working capital to account for the funds necessary to fulfill accounts payable obligations.

Establish Baseline Working Capital: Set a baseline working capital level as a reference point for the adjustment. This baseline can be determined based on historical averages, industry standards, or specific considerations relevant to the target company’s operations.

Conduct Due Diligence: Thoroughly analyze the target company’s financial statements during the due diligence process to accurately assess its working capital requirements. Identify any potential risks or anomalies that may affect the working capital adjustment.

Timely Completion: Ensure that the working capital adjustment is completed promptly after closing the deal to avoid prolonged disputes and uncertainties. Establish clear timelines and procedures for the adjustment process in the acquisition agreement.

Conclusion

Working capital adjustment is a crucial yet not much talked about aspect of business acquisition that requires careful attention and negotiation from both the buyer and seller. By accurately assessing and adjusting the target company’s working capital, both parties can mitigate risks, ensure fair valuation, and promote transparency in the transaction. Effective communication, thorough due diligence, and clear agreement terms are essential for successfully navigating the working capital adjustment process and facilitating a smooth transition post-acquisition.

About the author

Sarthak Agrawal
Sarthak Agrawal, a CFA Charterholder and MSc in Finance from the University of Manchester, serves as a Financial Analyst at dns corporate advisory. Specialising in investment management, financial due diligence, and transaction advisory, he guides clients towards their financial aspirations with precision and dedication.