Working Capital: Why You Need It and How to Calculate It - Acquira

Working Capital: Why You Need It and How to Calculate It

What You’ll Learn
  • 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

Introduction

In most business acquisitions, buyers perform due diligence to check the external and internal conditions of the business.

However, the financial side of the business is one that gets a lot of attention. This is because it signifies the profitability of the deal and the continuity of the business.

One tool used during this analysis of finances is the company's working capital. It determines the short-term efficiency of a business. We’ll explain what it is exactly, how to use it, and if it is sufficient as a financial analysis tool.

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. It is a short-term financial metric that tells how efficiently a business is running and meeting short-term obligations.

If defined formally, the working capital or net 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 (account 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 the working capital into your business purchase or price. Working capital is important because the net profit shown in the profit & loss account is not necessarily the cash available.

A general understanding is that you are left with net profit after paying all the bills, expenses, etc., and it should be in cash. But that does not exist practically.

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 in your hand as cash.

Therefore, you have to pay attention to a business’s net working capital when thinking of 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

The accounting for the calculation of working capital is very simple. You have to derive current assets and current liabilities from the business balance sheet and apply the following formula:

Net Working Capital =  Current Assets - Current Liabilities

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, sold on cash or credit, and receiving 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 current ratio helps to find the exact needs of a company. According to Investopedia, the current ratio “compares all of a company’s current assets to its current liabilities.”

Current ratio = Current assets Current liabilities

It is sometimes called the “working capital ratio”. Generally, a value above one and up to 2 is favorable.

The ratio above two generally symbolizes inefficient asset management. But the optimum level of working capital depends on the industry averages too. You might be working in an industry with an average current ratio of 3. In that case, your optimum current 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 the financial obligations. When the working capital is negative, current liabilities are higher than current assets, 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.

Debt-free transaction

Take for instance 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 equal to $800K in that case. When you receive the business, it is debt-free, and nothing is due on you. In short, the seller is responsible for paying off those debts with the purchase proceeds before they exit the business.

Cash-free transaction

Now we come to the cash-free part. The general perception is that the last penny of cash present in the business belongs to the owner (buyer). 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 acquisition by a new owner. 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 level of working capital 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 transaction closing. 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.

Is Working Capital Alone Enough for Financial Analysis?

Unarguably, 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 current 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.

Conclusion

The company’s working capital is indeed a significant financial metric that guides you about running 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.

Leave a Reply

Your email address will not be published. Required fields are marked *