Net Working Capital Targets: What to Know When Selling a Business
When selling a business, understanding the concept of net working capital targets is crucial.
Net working capital represents the funds available for day-to-day operations and reflects a company’s short-term liquidity. In a business transaction, net working capital targets play a significant role in determining the final purchase price.
Read on to learn the essentials of net working capital targets and how it can impact a business sale.
Definition of net working capital
Net working capital represents the difference between a company’s current assets and its current liabilities. It provides an indication of a business’s ability to meet its short-term financial obligations. Current assets typically include cash, accounts receivable, and inventory, while current liabilities encompass accounts payable and short-term debt.
Significance in business transactions
During a business sale, a net working capital target is established as part of the negotiation process. The target amount serves as a benchmark for assessing the financial health of the business at the time of the transaction. Buyers and sellers agree upon a specific net working capital target to allow for a smooth transition and to protect the interests of both parties.
Determining the net working capital target
The net working capital target calculation is often based on a historical average or percentage of the company’s revenue. It’s important to consider the industry’s characteristics and the business’s circumstances when determining the target. Seeking professional advice from accountants or certified valuation analysts (CVAs) can help verify a fair and accurate assessment.
Adjustments and working capital adjustments mechanisms
Working capital adjustments cover any discrepancy between the actual net working capital at the time of closing and the agreed-upon target. These adjustments protect the buyer from inheriting unexpected financial burdens or windfalls. Common adjustments include changes in accounts receivable, accounts payable, and inventory valuation. Detailed documentation and clear definitions of adjustments are essential to avoid disputes.
Impact on the sale price
Deviation from the net working capital target can influence a business’s final sale price. If the net working capital exceeds the target, the seller may receive additional compensation. Conversely, if the net working capital falls short, the purchase price may be reduced. Properly managing working capital leading up to the transaction is vital to verify a favorable outcome.
Strategies for sellers
To increase the sale value, sellers should focus on efficient working capital management. This includes assessing inventory levels, improving cash flow, and monitoring accounts receivable and payable effectively. By demonstrating a favorable working capital position, sellers can instill confidence in potential buyers and potentially negotiate a higher sale price.
How we can help
Understanding net working capital targets is crucial for sellers when selling a business. At CLA, we spend the time to discuss the importance of net working capital, how to determine an appropriate target, and effective ways to monitor working capital through the close process. We work with sellers to help navigate the transaction process more smoothly and maintain open communication with buyers throughout the negotiation process for a successful sale. Contact us for assistance.
Craig Arends is a principal at CLA and is the managing principal of CLA's private equity practice. Craig brings a concentration of experience in providing accounting and transaction structuring advice for leveraged recapitalizations, purchase accounting and SEC reporting, assessing quality of earnings, and GAAP accounting. He has far-reaching experience with critiquing financial models and reviewing target companies' financial performance to identify cost reductions and/or operating efficiencies Craig has more than 30 years of experience in public accounting serving public companies, private equity groups, and companies, including a term as principal in charge of a Big Four Capital Markets Group in Moscow, Russia. He has led financial accounting due diligence projects for private equity investor groups and venture capital funds, primarily in the technology, communications, and manufacturing industries, as well as assisting with Foreign Corrupt Practice Act matters ranging from investigation of payments made, validation of compliance with corporate policies, and review of proposed transactions to ensure compliance. When not working, Craig enjoys watching any sports, but his most favorite are baseball, football and soccer.
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