Make working capital work better for you
By Roman Basi—Whether you’re a company like Amazon or a small, local business, business owners need to understand the importance of working capital. This simply means a company’s available capital for day-to-day operations at any given time. It can provide measurements to determine a company’s operational efficiency and short-term financial health.
The basis of working capital is the calculation: the amount of a company’s current assets minus the number of current liabilities. To be considered a current asset, they must be an asset that can be converted into cash in a year or less. Some examples include cash equivalents, accounts receivable, inventory, and prepaid expenses.
In comparison, current liabilities can include current liabilities such as accounts payable, accruals, and other similar types of debt. When you subtract your current liabilities from your current assets, you get the working capital figure. The figure will be positive when there is an excess of current assets over current liabilities. While working capital plays a role as a financial measurement tool, it also plays a major role in mergers and acquisitions (M&A) transactions.
While the calculation may be simplistic, there are some differences when it comes to an M&A transaction. The calculation can get more complex because the formula is determined by the asset or stock purchase agreements. Some transactions may involve cash or debt in the calculation, while other transactions may exclude certain assets or certain liabilities, which in turn has an impact on the seller that can vary by spectrum. This spectrum is generally determined within the purchase price or working capital portion of the share or asset purchase agreement. Every time the decision is made, a goal is set. This means that the selling company’s operations before the target date could have a drastic impact on closing funds.
To put into perspective, for example, the language of an asset purchase agreement might state, “a purchase price of $6 million minus the amount by which working capital varies at the closing date from the six-month average of working capital.” The calculation method used is then described in the asset purchase agreement.
Therefore, a target is determined by a 12-month average that follows the closing date of the trade. At closing, if it exceeds the average monthly working capital balance for the 12 months before closing, the seller will generally walk away with more money at closing. However, if at closing it is less than the average monthly balance of the six months before closing, the purchase price may be reduced by an amount equal to the difference of the 12-month average.
Working capital is an important part when it comes to analyzing the efficiency of a company. When a company has positive working capital, it is generally in good shape to expand or at least maintain its current share price. Keep in mind that some companies operate with negative working capital just because of the nature of the business. (These include stock-based companies). Knowing how important this is and how it affects the business you are evaluating can help determine the viability of the business.
Roman Basi is a lawyer and CPA at Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. He co-wrote the article with Ian Perry, a staff accountant.