Financial Due Diligence - The Working Capital "Peg"
When buying or selling a business, net working capital is often a key point of negotiation. A working capital target or "peg" is based on historical working capital levels, but may not be considered closely till later in the deal process.
This article discusses net working capital from a financial due diligence perspective.
One important note is there is no accounting or legal definition of working capital. In general, working capital is calculated as current assets less current liabilities and represents what is required to run the day-to-day operations of a business, but can be defined several ways. The largest categories of working capital are typically cash, accounts receivable, inventory and accounts payable.
As most transactions are structured as acquisitions of stock or assets on a cash-free, debt-free basis, working capital is presented less excess cash which is referred to as net working capital.
From a buyer's perspective, you want to ensure the business is delivered with the assets and liabilities that you believe you are purchasing. In addition, you want to ensure the price paid for the business reflects deviations from a "normal" working capital amount. In other words, you want to ensure any "excess" liabilities are deducted from the purchase price.
From a seller's perspective, you want to ensure that the consideration you receive is what you think it should be and any "excess" assets that are transferred to the buyer (i.e., when there is higher than "normal" working capital) results in higher consideration.
Key Areas of Focus in Financial Due Diligence
Depending on the depth of work requested or required for a deal, below are certain key areas of focus for a strategic investor, private equity investor or bank.
Definition and assessment of working capital for the purpose of the Sale and Purchase Agreement (SPA) negotiation and completion adjustments
Areas of subjectivity and value of working capital
Assessment of reasonableness of forecast working capital assumptions
Level of future borrowing requirements and forecast borrowing
Controls over working capital and quality of working capital assets
Improvement opportunities to working capital management
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Disclaimer: The information contained in this article is for general guidance only. The information presented should not be acted upon without the advice and guidance of a professional tax, legal, or financial adviser who is familiar with all the relevant facts.