General definition. Current assets – current liabilities = Net Working Capital
In most cases the valuation of a business does not include the net working capital of the business at the time of the valuation. Working capital is often excluded from valuations so that business values can be compared to other similar businesses without the need to adjust for working capital. If 2 businesses are identical except one has $1,000,000 in excess cash it won’t affect the valuation comparison because the excess cash is not in the valuation price for the businesses.
However, the working capital can affect the actual selling price of a particular business if the working capital is included in the sale.
Let’s say Business A is valued at $5,000,000 and business B is valued at $5,000,000, both without working capital. If business A has $700,000 in net working capital and business B has $1,500,000 in net working capital, and the buyer wants to buy the working capital with the business, then business A will sell for $5,700,000 and business B will sell for $6,500,000 even though both were valued at $5,000,000.
Many buyers want to buy a business with adequate or normal working capital. By doing this the buyer has a set amount of capital to raise that allows them to purchase the business. This capital to buy the businesses is likely long term capital. By including working capital in the purchase, after the sale, the business can operate on the purchased working capital.
The larger the transaction the more likely that working capital will be included in the business sale. The working capital target number (i.e., the amount specified in the LOI to be included in the purchase price) is an important negotiated element of a deal. In the LOI it might be a dollar amount or often an agreed to formula (since the working capital moves virtually every day the business is open) to use to get to a working capital number at closing. Make sure all elements of the working capital calculation is defined and understood.
Common Working Capital Elements
(with notes on the tricky ones);
- Cash and cash equivalents
- Accounts receivables
- Deposits – Deposits business has at vendors or other i.e., tax deposits, lease deposits, etc)
- Work-in-Progress – Does your accounting system account for this properly? WIP can also be a liability depending on billing practices.
- Accounts payable
- Accrued payroll
- Vacation owed employees
- Gift certificates Does your accounting system track?
- Warrantys Outstanding for products or services
- Prepaid service or maintenance agreements
- Deposits from customers