The due diligence (DD) process in mergers and acquisitions (M&A) is a critical step to ensure a successful transaction. One of the key areas of focus during DD is net working capital (NWC), which refers to the difference between a company’s short-term operational assets and liabilities. NWC is an important metric, as it indicates the amount of capital required to run the company’s day-to-day operations.
In M&A transactions, determining the normal level of NWC is crucial because it directly impacts the final purchase price, assuming the appropriate purchase price mechanism is applied. It’s essential for the buyer to understand the amount of working capital typically needed to maintain business operations, and to ensure that they do not overpay or face unexpected funding needs for working capital after the transaction.
What is Net Working Capital and Why Does it Matter in M&A?
NWC is made up of a company’s current assets (such as accounts receivable, inventory, and other non-interest-bearing receivables) and current non-interest-bearing liabilities (such as accounts payable and other short-term obligations).
There isn’t really a perfect general definition, but there are principles. Working capital items are operational in nature, they convert into cash relatively quickly, and thirdly, they are constantly revolving. (There is some good discussion on this topic in Heiko Ziehms’ book ‘M&A Disputes and Completion Mechanisms’, 2019, which I can recommend to anyone interested in purchase price mechanisms.)
The level of NWC often affects the final purchase price, as buyers generally want to ensure that the company retains a “normal” level of working capital, sufficient to sustain ongoing operations. If the NWC level is not properly defined, the buyer may either overpay for the company or have to inject additional capital post-transaction to maintain operations. This could lead to cash flow issues and negatively affect business continuity immediately following the acquisition.
Properly determining the NWC level ensures that the purchase price reflects the company’s true financial condition and the required investment to sustain operations. The assumption that a normal level of working capital is included in the transferred balance sheet is also a key element of commonly used valuation theory when determining the enterprise value of a company.
Determining the Normal Level of Net Working Capital
Determining the normal level of NWC in M&A transactions is not straightforward. It requires a careful analysis of historical data, along with consideration of potential future developments. Key steps in the process include:
- Historical Data Analysis: The process begins by analyzing the company’s historical NWC levels, usually over the past 12 to 24 months. This provides insight into how much working capital the company has needed at different times and helps identify any seasonal trends.
- Considering Seasonal Variations: Many businesses experience seasonal fluctuations in their working capital needs (e.g., in retail or manufacturing industries). It is important to ensure that the normal level of NWC reflects typical seasonal variations in the business rather than relying on data from a specific point in time.
- Eliminating Anomalies: The company’s history may include one-off events, such as temporary inventory build-ups or reductions, delayed payments of accounts payable, or bad debt write-offs, that could distort the normal level of NWC. These anomalies should be removed to get a clear picture of the company’s true working capital requirements.
- Future Outlook and Business Growth: The buyer must assess whether the company’s future working capital needs will be higher or lower due to business growth or strategic changes. For instance, expansions or new product launches may require significantly more working capital than the historical level.
- Identifying the Right Financial Metrics: While this may seem obvious, it’s common in M&A transactions that comprehensive financial data representing the complete business picture is not readily available. In such cases, pro forma calculations may need to be created, which can be a complex, standalone exercise.
Conclusion
The due diligence process in an M&A transaction involves many important elements, but determining the normal level of net working capital is one of the most critical. Analyzing historical data, accounting for seasonal variations and anomalies, and considering the company’s future outlook helps establish the optimal level of working capital for the business. This is vital for the buyer to ensure financial stability and reduce risks after the transaction.
For a broader view of what to keep in mind during due diligence, I recommend reading Toni’s thoughts in the following article: Laadukkaan due diligence -prosessin muistilista – Capton Partners. For tax considerations, check out Lauri’s post: Miksi verotuksellinen Due Diligence on oleellinen osa yrityskauppoja? – Capton Partners. Both in Finnish.