Most M&A deals include working capital, current assets less current liabilities, as part of the purchase. The objective of setting an adequate target working capital amount is to ensure that the buyer can get through an operating cycle without providing any additional funding. Therefore, it is important during the due diligence to establish what working capital is required to continue the business without the buyer having to put in additional cash, which in essence would be additional purchase price.
Establishing a base line is the first step to determining the “target” working capital. In a typical situation, the average working capital over a trailing twelve months (TTM) might be used as a target. In this case you would want to ensure that there are no anomalies or one-time events included in those calculations that would distort the average. Diligence of the components of working capital for the trailing twelve months would disclose such items. Comparing monthly balances over the TTM would give the buyer some indication of large swings. Also, a thorough understanding of the composition of each component will provide additional comfort as to the quality of the components.
Key components that you would want to “diligence” typically include accounts receivable, inventory, accounts payable and any estimated liabilities. For example, understanding credit policies, collection history and credits will allow you to understand what you can expect to collect on accounts receivable and have available to pay current liabilities.
In many cases there are other factors that can complicate determining an adequate working capital target. Seasonality of the business, a recent upswing or downswing in revenue, a new contract - are a few of the items that may complicate the situation. For example, in the case of a retailer who is seasonal you may want to look at past historical amounts around the time of the closing to determine a target.
Also, utilize the “sniff” test. Look at trends in certain ratios such as sales to working capital and the number of days in an operating cycle (cash to cash) to help you validate the target working capital you require.
It is important to not wait until the last minute to determine the working capital provision. Have the sales agreement include a detailed example of the calculation of working capital, so it is clear what is included and what isn’t. Open conversation and discussion between the parties will facilitate a broader understanding of required working capital and prevent post-transaction disputes.