Mergers and acquisitions (M&A) can be a great way for businesses to expand their operations, enter new markets, and increase profitability. One of the most critical metrics to evaluate the financial health of a target business is its working capital, which measures the company’s operational liquidity. Essentially, a positive working capital amount indicates that the company has enough cash available to fulfill its short-term obligations without resorting to additional borrowing or asset liquidation. In M&A, working capital is often a significant area of negotiation between the buyer and the seller.
When it comes to measuring working capital for an M&A transaction, there are several considerations that should be taken into account. Below, we will discuss the importance of working capital in an M&A transaction and provide tips on how to manage it effectively.
What Is Working Capital?
The measurement of a company's liquidity and financial health is referred to as working capital, or net working capital. It is determined by taking the difference between current assets and current liabilities, which encompasses cash, inventory, accounts receivable (A/R), accounts payable (A/P), and other short-term debt obligations.
In the tire business, most M&A deals follow a "cash-free, debt-free" structure, where the buyer gets to keep the cash in the bank, but long-term debt is the seller's responsibility. Consequently, the working capital formula used in these transactions can be shown as:
(A/R + Inventory) – (A/P + Accrued Expenses) = Net Working Capital
Working Capital as Part of an M&A Transaction
When evaluating a potential acquisition target, buyers will typically want to see a high level of working capital. This indicates that the target company is financially stable and has the ability to meet its short-term obligations, such as paying suppliers and employees. A high level of working capital also suggests that the company has a strong business model and is generating positive cash flow to finance future growth. On the other hand, a low level of working capital may raise red flags for potential buyers, as it may indicate that the company is struggling financially and may not be able to meet its short-term obligations.
During M&A negotiations, working capital refers to the additional funds required to finance the deal, including items such as cash reserves, inventory, accounts payable and receivable, debt payments, payroll expenses and related costs. A successful closing requires both parties to agree on the required working capital and how it will be managed in the new company. For sellers, this means ensuring that the buyer has enough resources to operate the business immediately after the acquisition.
Since a company’s working capital changes over time, it is critical for buyers and sellers to review any changes during the transaction process and once again at the time of closing. To protect the buyer from unfavorable circumstances, such as inventory liquidation, both parties must agree on a net working capital figure before closing the deal and make adjustments, as necessary. Financial advisors can be extremely helpful in instances where a client has had excess working capital (e.g., inventory) and was compensated above and beyond the expected proceeds of the value of the company.
Working Capital Adjustments
One way for buyers to protect themselves from inheriting the target company's liabilities while maintaining the value of their purchase is through working capital adjustments. This entails adjusting the purchase price up or down based on changes in the target's working capital between the initial signing and closing dates. The adjustments ensure that any significant changes in working capital during this period are accounted for when calculating the final purchase price.
For instance, if the target's working capital increased from $1 million at signing to $1.2 million at closing, the buyer would adjust the purchase price up by 20%, providing the seller with an additional $200,000 in cash. Conversely, if the working capital decreased from $1 million to $800,000, the buyer would adjust the purchase price down by 20% to avoid taking on extra liabilities.
In multi-store transactions, the Letter of Intent to Purchase (LOI) typically includes a reference to a "normalized level of working capital," which both parties must agree upon. This level is determined by analyzing the target's working capital changes over the past 12 to 24 months in relation to sales and seasonality.
A high level of working capital in the target company can help ensure a smooth transition and future growth. The final agreement on working capital will depend on the specific needs and goals of both parties. Understanding and incorporating working capital into negotiations can ensure maximum value and protect against unanticipated costs and lead to a fair and successful transaction.
Giorgio Andonian is a Managing Director in FOCUS Investment Banking’s Auto Aftermarket Group. With a lifetime spent in is family’s automotive business, he now advises and assists privately held middle market auto aftermarket companies with mergers and acquisitions. Contact Giorgio at [email protected].