Working capital is a critical component of a company's financial health, representing the difference between current assets and current liabilities. It serves as a measure of a company's short-term liquidity and operational efficiency. Evaluating working capital during financial due diligence helps investors and stakeholders understand a company's ability to meet its short-term obligations and maintain day-to-day operations.

Working capital analysis is essential for several reasons:

• Liquidity assessment: Working capital provides insight into a company's liquidity position. Sufficient working capital ensures that a company can cover its short-term liabilities, such as accounts payable, wages, and other operational expenses. A strong liquidity position indicates financial stability and reduces the risk of insolvency.
• Operational efficiency: Analyzing working capital helps assess how efficiently a company manages its current assets and liabilities. Efficient working capital management indicates that a company can effectively turn its inventory and receivables into cash, optimizing its cash flow.
• Financial flexibility: Companies with positive working capital have the financial flexibility to invest in growth opportunities, manage unexpected expenses, and navigate economic downturns. This flexibility is crucial for maintaining competitiveness and sustaining long-term growth.

For a merger and acquisition (M&A) transaction, the calculation of working capital is completed on a cash-free, debt-free, and tax-free basis and called net working capital. Net working capital is further refined and adjusted to exclude non-operational assets and liabilities, non-recurring items, debt-like items, and seasonal variations.

• Removing non-operational assets and liabilities: These are items that are not part of the core business operations and can skew the working capital calculation. Examples include investments, loans to related parties, or deferred tax liabilities.
• Excluding non-recurring items: Non-recurring items are one-off transactions that do not reflect the company's regular operations. Examples include legal settlements, restructuring costs, and proceeds from the sale of non-core assets.
• Debt-like items: Debt-like items are liabilities that may not be classified as traditional debt but have similar characteristics, such as obligations to pay, which typically need to be removed from the working capital calculation. Examples include deferred revenue/customer deposits, contingent liabilities, and accrued year-end bonuses.
  • Once the adjusted net working capital is reviewed by both the seller and the buyer, the negotiation on the net working capital target begins. The agreed-upon net working capital level serves as a benchmark to ensure that the target company has sufficient working capital to operate post-acquisition.

The negotiations typically include the following elements, which are also reflected in the purchase agreement:

• Setting a target working capital: Both parties agree on a target working capital level based on historical performance, industry benchmarks, and future operational needs. This target serves as a baseline for adjustments.
• True-up mechanism: This involves comparing the actual working capital at closing against the target. Any shortfall or excess is typically adjusted in the purchase price to ensure the buyer receives a business with adequate working capital.
• Dispute resolution: Establishing clear terms for resolving disputes related to working capital calculations is essential. This may involve using independent auditors or agreed-upon methodologies to settle disagreements.

Navigating the net working capital adjustments and negotiation process can be complex and challenging for both the seller and the buyer. Understanding the nuances of adjusted net working capital, setting appropriate targets, and negotiating fair terms requires careful analysis. However, it is important to recognize that specialized help is available to guide either party in the transaction through these intricacies. By contacting the experienced professionals in Citrin Cooperman’s Transaction Advisory Services Practice, the client – whether they are a seller or a buyer – can ensure a thorough and accurate assessment, leading to more informed decisions and successful transactions.

Citrin Cooperman’s dedicated Transaction Advisory Services Practice’s team is well-equipped to help you evaluate the financial health of your organization. For more information, please contact Sylvie Gadant, Ardi Nugraha, or your Citrin Cooperman advisor.