The simple definition of Working Capital is Current Assets – Current Liabilities. But in real world application it is much tricker and is frequently the source of heated disagreement between buyers and sellers.
Working capital is used to fund operations and meet short-term obligations. If a company has enough working capital, it can continue to pay its employees and suppliers and meet other obligations, such as interest payments and taxes, even if it runs into cash flow challenges.
Sellers often view cash and accounts receivables as “money in the bank”. What they must realize however is that these assets are used to fund operations and pay bills. For businesses that run 30, 60, 90 days out or more on their collections, a buyer will have to fund operations during this period. For this reason, a buyer will want to retain sufficient Accounts Receivables, cash etc. to remain in a healthy financial position.
In addition, the buyer in purchasing the business is purchasing future profits. Without retained Working Capital these future profits will evaporate – at least in the near term.
Here are some examples of current assets that can make up WC
Current Assets
(Liquid assets that can be converted into cash within 12 months)
- Cash
- Marketable securities
- Short-term investments
- Accounts receivable, minus any allowances for accounts that are unlikely to be paid
- Notes receivable — such as short-term loans to customers or suppliers
- Other receivables, such as income tax refunds, cash advances to employees and insurance claims.
- Inventory including raw materials, work in process and finished goods.
- Prepaid expenses, such as insurance premiums.
- Advance payments on future purchases.
Current liabilities
(Liabilities due to be paid within 12 months)
- Accounts payable.
- Notes payable
- Wages payable.
- Taxes payable.
- Interest payable on loans.
- Any loan principal that must be paid within a year
- Other accrued expenses
- Deferred revenue, such as advance payments from customers for goods or services not yet delivered.
It is critical that buyer and seller reach agreement early in the process on how Working Capital is to be calculated. Working Capital is often a moving target and cannot be accurately determined on the day of closing. For this reason, buyer and seller will often agree to escrow some of the proceeds to cover potential WC shortfalls.
Selling a business can be a complicated process. Therefore, you need to hire only the best professionals. At Quorum Business Advisors we have the experience and skills to help you.
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Anthony John Rigney
Broker/ Owner
Quorum Business Advisors, LLC