- The definition of working capital and how to calculate it
- Why working capital is important in any business acquisition
- The limitations of working capital as a financial analysis tool
- How to interpret the working capital of a business
Working capital isn't something most business owners think about on a daily basis, but it can often be the key to a company's success.
Working capital affects a number of aspects of the business, including payroll, vendors, and operating expenses. A company's working capital helps you plan for sustainable long-term growth and also ensures you're able to meet your current, short-term obligations. Given that it has such far-reaching effects, it is vitally important that any Acquisition Entrepreneur understands what it is, why they need it, and how to calculate it.
That includes calculating your current levels, projecting your future needs, and looking for ways to ensure you always have enough cash on hand.
In this article, we'll explain what working capital is and how to use it.
What is Working Capital?
In simplest terms, the working capital of any company is like the fuel in a car — essential to keep moving. It represents the amount that a business owns for meeting its day-to-day obligations and operations. In the short term, it is a financial metric that shows how efficiently a business is running and meeting its short-term obligations.
If defined formally, working capital is the difference between a business’s current assets and current liabilities.
The current assets represent the part of business assets that are cash or easily convertible to cash within 12 months (cash, cash equivalents, account receivables, notes receivable).
The current liabilities represent the short-term obligations due within 12 months (accounts payable, outstanding salaries/wages, notes payables, etc.).
An illustration of working capital
A company ABC Inc. has $100,000 as cash deposit, $300,000 as debtors, and $150,000 in short-term securities.
The current liabilities of the company (debt) is equal to $300,000.
The current assets: ($100,000 + $300,000 + $150,000) is equal to $550,000.
Since the working capital is the difference between current assets and current liabilities:
Net working capital of ABC Inc.: ($550,000 – $300,000) is equal to $250,000.
This amount shows that the company has $250,000 working capital for meeting day-to-day obligations.
Why Do You Need to Factor Working Capital into Your Business Purchase?
When you’re buying a business, you need to factor working capital into the purchase price. Working capital is important because the net profit shown in the profit & loss (P&L) report is not necessarily the cash available.
Net profit is calculated after paying all of a company's bills, debts, and other expenses, and it should be in cash. But in reality, this is very rarely the case.
A company’s net profit is a theoretical value that shows the net effect of business transactions during the financial period. On practical grounds, the working capital represents what you actually have on hand as cash.
Therefore, you have to pay attention to a business’s net working capital when looking at acquiring it. A business that looks profitable on paper might go bankrupt. The importance of working capital is higher because most businesses follow the accrual accounting basis. Any transaction, when it happens, becomes part of business regardless of when proceeds are received or paid.
Even the businesses making $1 million in monthly sales can have low operational efficiency if they are on credit and have a high bad debt rate.
How to Calculate Working Capital
In order to get a sense of where the business is standing at any given time, your working capital ratio will provide a measurement of the company's short-term financial health.
The working capital formula is calculated as:
Current assets / Current liabilities = Working capital ratio
So, if the company has current assets of $1 million and current liabilities of $500,000, the working capital ratio is 2:1. In general, that's considered a healthy ratio. There may be some industries where a ratio as low as 1.2:1 would be considered adequate.
Your net working capital tells you how much money you have readily available to meet current expenses:
Current assets – Current liabilities = Net working capital
For these calculations, you should only consider short-term assets like the cash in your business account and the money your customers owe you (ie: accounts receivable), plus any inventory you expect to convert to cash within 12 months.
Short-term liabilities include the money you owe vendors and other creditors (ie: accounts payable) as well as other debts and accrued expenses for salary, taxes, etc.
What this means
Let’s explore it under different contexts…
1. Liquidity or cash flow
The primary implication of working capital management is assessing a company’s liquidity, efficiency, or cash flow management. In a typical cash conversion cycle, the cash is used to pay for raw materials, and the raw materials are converted to finished goods, which are sold on cash or credit and received as cash.
The positive value of working capital signifies that the company has enough cash to meet the operations. Similarly, a negative value or lower value means the company is unable to meet its current obligations with cash. So, the working capital is an important measure to know a company’s liquidity in the short run.
2. Cash management
The working capital factors cash and cash equivalents, and working capital management calls for identifying the amount of cash that a business will need in the short run.
After identifying the cash requirement, the business owner can decide to earn a return from short-term investments.
Positive working capital is good for a company’s health, but too much working capital indicates inefficient management of current assets. For instance, the company could’ve earned interest or return by investing the excess cash.
Too much working capital indicates inefficient management of current assets.
For this purpose, the working capital ratio mentioned above helps to find the exact needs of a company. The optimum level of working capital depends largely on industry averages. You might be working in an industry with an average current ratio of 3. In that case, your optimum working capital ratio level will be three times more current assets than current liabilities.
3. Short-term financing
The level of working capital in any business also drives the decision to apply for short-term loans to meet financial obligations. When the working capital is negative, current liabilities are higher than current assets, and the company’s management decides to go for short-term financing like a business line of credit, bank loans, etc.
How to implement working capital in your acquisition
Working capital is significant in buying a business. Typically, a business acquisition is cash-free and debt-free. It means that you do not purchase any liabilities of the business. Similarly, the seller will not leave any cash they earned in the company.
If you bought a business for $1 million and pay the money to the buyer, but the current liabilities of the business are equal to $200,000. The debt-free transaction implies the buyer will pay the debts out of the $1 million you’ve paid.
Their net proceeds will be $800K in that case. When you receive the business, it is debt-free. In short, the seller is responsible for paying off those debts with the purchase proceeds before they exit the business.
The general perception is that the last penny of cash present in the business belongs to the owner (seller). It sounds reasonable as the seller has earned all the money. But here is a twist:
The seller cannot take all the cash from the business after it has been acquired. When the new owner steps into business, they will need working capital to keep the business running.
“Business needs to keep running, which means you’re still doing work, which means your recurring cost of goods, which means you’re still accruing bills and all this stuff that needs to be paid.
“So there’s a certain amount of net working capital that needs to exist even after the sale. And that’s included in the whole purchase of the business,” says Kylon Gienger, President of Acquira.
Acquisition and working capital
Net working capital is included in the negotiation between the seller and the business buyer at the time of acquisition. If you recall the formula, current assets minus current liabilities is equal to working capital. As a buyer, you will assess the net working capital needs for the last 12 months or less.
It will give you a good idea of what is generally required to keep the business running when you move in.
In many acquisitions where buyers finance the purchase from loans, lenders issue a check in favor of the buyer at the close of the transaction. It is amortized along with the purchase loan or line of credit you’ve acquired.
The lender issues the check as net working capital for the business when you step in. In that case, the seller might take away all the cash from a business.
Funding Growth: How Do You Get Working Capital?
Planning for working capital is an excellent way to fund your company's post-acquisition growth initiatives. After all, one of the key components of Acquisition Entrepreneurship is growing the business, increasing its value, and selling it for more than what you paid.
When it comes to business acquisition, there are a few ways you can ensure working capital is included in the deal. Namely, you can overfund the SBA loan or you can get a line of credit (LOI).
If you're looking to overfund the loan, it's good practice to ask for 5 percent of the purchase price. That extra 5 percent can be used as you see fit, generally for growth-related expenses like the ACE Framework or working capital.
Keep in mind, you can't have equity in any business that you are planning to contract with the cash you receive from the loan. So, if you also own an IT company that you're planning on contracting to improve the systems at your new HVAC company, you can't receive funding from an SBA loan to pay for that.
A line of credit is generally more attainable for most borrowers, but this will often come down to the borrower's credit history and the lender's internal policies. Ideally, you should strive for both. That way you can use the LOC as a float, just in case you need it for an emergency.
Is Working Capital Alone Enough for Financial Analysis?
Net working capital is a very strong financial metric to assess and analyze a business. However, it is not enough to rely on working capital alone to perform financial analysis.
Working capital is just one metric among many that help to analyze the short-term efficiency of a business.
Why it isn’t sufficient on its own
- The net working capital of a company only focuses on the company’s cash flow and cash transactions. The working capital concept of funds omits many financial and investment transactions that significantly impact overall business health.
- The working capital ratio is a more objective measure of a company’s operational efficiency. The reason is that you can compare the current ratio with industry averages, other competitors, and companies with similar capital structures.
The company’s cash conversion cycle also plays an important role when analyzing the operational efficiency of a business.
A company’s working capital is indeed a significant financial metric that can help you decide how to run the day-to-day operations of a business. As an Acquisition Entrepreneur, performing working capital analysis and negotiating with the seller is critical. However, you cannot rely on working capital analysis as an independent and stand-alone factor.
In short, having working capital as you enter your new business is necessary. But from an analysis point of view, consider other metrics as well to identify working capital requirements.
Part of Acquira's training includes an SBA calculator, which helps you determine how much working capital you'll need to help grow your business. It's just one aspect of the extensive training and tools we provide through our Accelerator Program. To learn more, schedule a call with an Acquira Representative today through the form below.
- Working capital is a financial metric that shows how efficiently a business is running and meeting its short-term obligations.
- When you’re buying a business, you need to factor working capital into the purchase price.
- The primary implication of working capital management is assessing a company’s liquidity, efficiency, or cash flow management.
- When attaining working capital during an acquisition, you should overfund the purchase price by 5%.
Acquira is a business acquisition in a box service. We help entrepreneurs buy businesses and we invest in them and their chosen businesses. We are here to help ensure that each business we work with is posed to make the biggest positive impact possible for its owners, employees, and community.
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