Working Capital


Think of working capital as the money available to meet your current, short-term obligations. In accounting terms working capital is comprised of 4 types of accounts.

  • Cash and cash equivalents.

  • Accounts receivable (A/R)

  • Inventory raw materials, WIP and finished goods

  • Accounts payable (A/P) including debt


And is expressed in the following general formula as follows.


Working Capital = Cash and cash equivalents + A/R +Inventory - A/P - Debt


A buyer is concerned with your level of working capital as it is one of the measures of operational efficiency, liquidity and short-term financial health. If a company historically has a large positive working capital balance, then it should have the potential to invest and grow. On the other hand, if the historical working capital is low or negative, the company is in poor financial health and in danger of going bankrupt - not something a typical buyer would consider a good sign!


Working Capital Adjustment at Close


When a buyer submits an LOI they will have an idea of the state of your working capital from their initial due diligence and will expect working capital to remain at roughly that level through the close unless there are seasonal factors at work which can be demonstrated from your historical working capital balance. If working capital at close is less than the expected level by a material amount, the buyer will demand a net working capital adjustment to true up working capital. The working capital adjustment is, in its essence, a mechanism to protect the Buyer by assuring that at closing the target will have the level of net working capital required to deliver the financial performance that formed the basis for the purchase price. In plain English, if you run down your inventory and accelerate customer payments between accepting an LOI and the close, you will be required to make up the difference. If a seller note is involved, the buyer will often take the shortfall in working capital out of the note, effectively reducing the price they are paying for your company because you took cash or other assets out of the business in a way that is inconsistent with the normal operations of the company.

For more on this topic see Who Owns A/R, A/P and Inventory?