Corporate Finance
Feb 20, 2023
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This guide will explain how net working capital is assessed during due diligence in an M&A deal. This guide will focus on how net working capital is one of three main focuses for financial due diligence, and how it is normally assessed. Here are some key takeaways about net working capital assessment during due diligence:
When we're talking about mergers and acquisitions, due diligence refers to the formal process that the buyer takes to inspect the business they are about to buy. There are four main areas where due diligence is normally conducted:
This guide will focus on financial due diligence. For more information on the different types of due diligence, we recommend our guide: Four Main Areas For Due Diligence.
Financial due diligence typically has three main focuses: quality of earnings, net debt & debt-like items, and net working capital. This guide will focus on net working capital.
In addition to quality of earnings and net debt, we need to understand net working capital if we are to understand the full picture of what buyers are looking for during due diligence.
Net working capital (NWC) is the difference between a business’s current assets and current liabilities (found on its balance sheet).
When we talk about assets and liabilities as being "current", we're referring to an expected lifespan of 12 months. This means that current assets are expected to be used or sold to customers, and current liabilities are due within 12 months.
Current assets are normally comprised of cash, inventory, and accounts receivable. Current liabilities are normally accounts payable and debt.
In mergers and acquisitions, NWC is most commonly calculated by excluding cash and debt (current portion only). So, for net working capital, we're looking at current assets of accounts receivable and inventory and current liabilities of accounts payable. The cash and debt that we have excluded from our calculation will be addressed later on in the definitive purchase agreement.
Net working capital is an indicator of a company's liquidity and its capacity to meet short-term obligations and fund business operations. Ideally, a company should have a positive net working capital balance, which means having more current assets than current liabilities.
A good way to look at it is that NWC helps us to understand if a business is generating cash from its working capital or consuming it.
Now that we've explained what net working capital is, we'll look at how it fits into the due diligence process.
It is normally first discussed in the letter of intent (LOI).
Typically, the LOI will require the seller to deliver a "normal level" of working capital—often called a "working capital peg". This part of our due diligence aims to determine what is "normal" for the business.
When accurately calculated, the working capital adjustment (post-close) should not favor either the buyer or the seller; its purpose is to maintain neutrality.
However, the difference between the peg and the closing net working capital that we agree to during due diligence will affect the purchase price. As a result, the buyer and seller have conflicting motivations: the buyer aims for the highest peg, while the seller aims for the lowest peg. A higher peg will mean that more cash is required to be left in the business at closing (to fund working capital).
So ultimately, this is a negotiation.
Here, we'll briefly explain why net working capital is a major point of focus during due diligence.
Ultimately, it comes down to the fact that sellers can artificially reduce their working capital, especially in the short term, without greatly affecting EBITDA. There are three ways they can do this:
These three things will reduce working capital, but aren't necessarily sustainable over the long term. Remember that a net working capital calculation for purposes of an M&A transaction should not benefit either the seller or the buyer, it should be reflective of "business as usual".
This concept may be somewhat confusing for business owners because often management strives to improve working capital.
From an operations standpoint, it always makes good business sense to try and reduce working capital funding gaps and improve cash conversion cycles. While this is a good business practice in general, there is also probably a good reason why the seller hasn't already made these changes in their business already. If this made good business sense all along, this would have been the norm. In practice, there are good reasons why working capital would be the way it is. Maybe you offer customers favorable financing terms and this results in more sales made. Maybe you pay suppliers on an accelerated schedule in exchange for a discount.
So for purposes of an M&A deal, versus management's focus on improving working capital, we want to look at what net working capital would be from a standpoint of business as usual.
Understand that the buyer's due diligence team is ultimately looking to understand what business as usual looks like and to determine what is "normal" from a working capital standpoint.
If the seller were to try and artificially reduce net working capital through the three methods we listed above, it could have several outcomes for the buyer:
The buyer is concerned about these things. Basically, if they underestimate what net working capital is, then they will need to make a capital injection into the business to fund operations. They are trying to avoid this as it carries huge potential risks for them.
