What Is Normalised Working Capital and why is it Important?
One of the key considerations when you are buying a business is ensuring that there is sufficient Working Capital left in the business at completion for the business to function. However, understanding what is sufficient Working Capital is often a subjective and complex area, and it can have a significant impact on the total consideration payable in a transaction.
WHAT IS NORMALISED WORKING CAPITAL?
In a typical transaction, a Buyer and Seller will agree a headline value for the business. The value of a business is generally calculated using various valuation methodologies, but the most common approach is to apply a multiple to the company’s Maintainable Earnings Before Interest Tax Depreciation and Amortisation (EBITDA)/Earnings.
The valuation is considered to be the Enterprise Value of the business and is before any adjustments are made for surplus cash and outstanding debt normally stated as cash free, debt free. It is generally assumed that a Seller should keep all the cash generated prior to completion and notionally pay off all outstanding loans at completion. Therefore, cash is added to the Enterprise Value and debt is deducted.
However, the buyer is buying a functioning business so it is implicit in the valuation that there is sufficient funds (Working Capital) in the business to function normally so that there is no immediate cash crunch post completion. The difficulty comes in determining what is a ‘sufficient’ level of net Working Capital.
What does working capital represent?
Net Working Capital is broadly defined as the current assets of a company, minus current liabilities. Key components typically consist of Accounts Receivable, Stock/Work in Progress, Accounts Payable and Payroll Liabilities.
It is a measure of funding requirement needed for the Company to trade on a day-to day basis ultimately its ability to meet short-term obligations, as well as fund
operations of the business.
WHY IS NORMALISED WORKING CAPITAL IMPORTANT
The Heads of Terms usually specify the purchase price on a cash free, debt free basis and it will state that the price is subject to normalised level of Working Capital at completion (a normalised Working Capital ‘Target’ will be established as part of the financial due diligence and agreed between the parties).
If the net Working Capital at completion is higher than the ‘Target’, the buyer often pays the seller the excess amount, on a pound-for-pound basis, which effectively increases the price. In the evet that the net Working Capital at completion is below the ‘Target’ then the price is adjusted downwards. Based on this price adjustment mechanism it is in the Buyer’s interest for the Target to be as high as possible, whereas the Seller will want the Target to be as low as possible (to give them the best chance at delivering Working Capital above the Target at completion, and therefore increasing their proceeds!).
The Target normalised Working Capital safeguards both the Buyer and the Seller from any one-off Working Capital movements or trends in the run up to completion, for example:
- In the run up to completion Sellers may be tempted to slow payments to
creditors to increase the cash balance at completion. However, by doing this
the creditor balance will be higher than normal resulting in the Working Capital
position being lower than the target and a corresponding reduction in the
price. - Conversely if a large customer who typically pays within 45 days suddenly
pays an invoice early, the Company’s cash balance will have increased. The
increase cash will increase the price paid to the Seller. However, the Buyer is
protected as the Trade Debtors balance will be lower than normal (normal
levels are based on receipts in 45 days). The lower Trade Receivables would
result in the Target Working Capital being missed and a corresponding
reduction to the price.
CALCULATING NORMALISED WORKING CAPITAL
Calculating normalised Working Capital for any company is subjective. A proposed figure will be calculated as part of the financial due diligence. The figure might be calculated as an average over the previous 3, 6 or 12 months adjusted for potential one-off transactions or outliers.
There is no standard definition on how to calculate a normalised Working Capital ‘Target’, with the calculation differing from transaction to transaction and advisor to advisor. Therefore the target figure is normally a key negotiation between a buyer and seller. If the Target is not set at the right level it can lead to potential value gain/loss for either party.
The process for establishing a Target for normalised Working Capital will include:
- Agreeing what is Cash and Debt-like items:
o On the face of it this is an easy definition but there are often various components which are negotiated on. For example, deferred income – when cash has been received from a customer in advance of the service/product being delivered. It can be argued either way whether this is a debt-like item, or a working capital item. - Establishing which items relate to Working Capital:
o Review of the average Working Capital levels within the business, to assess the normal Working Capital removing any peaks or troughs due to seasonality. Typically, this is measured over the last 12 months, however for growing businesses the calculation may be based on a number of actual months and forecast months.
o The Buyer (and Seller) will prepare a net working capital analysis as part of the financial due diligence. This review will typically look at Working Capital trends (e.g. seasonality) and any one-off large movements. For example, adjustments may be proposed for the following areas, in arriving at a ‘normalised’ Working Capital figure:
• Adjustments for slow moving or obsolete stock.
• Adjustments for significantly overdue receivables or payables
e.g. >90 days overdue
• Adjustments for one-off items – such as large creditors relatingto capital expenditure, or working capital items relating to one-off
projects.
• Adjustments to reflect differences between month-end and year-end accounts (to ensure comparing like with like when it comes to the completion accounts). For example, detailed work in
progress calculations might only be carried out at year end.
HOW IS VALUE IMPACTED
Once the transaction has been completed, there is will normally be a set of Completion Accounts prepared. This will determine the level of cash and debt, as well as Net Working Capital at completion – which is then compared against the ‘Target’ Working Capital. The price is then adjusted based on the actual difference compared to the target up or down.
It is important that both buyers and sellers undertake a thorough assessment of Net Working Capital, in order to ensure that am appropriate Working Capital ‘Target’ is set.
