Net Working Capital Explained

Accounting can sometimes seem like a foreign language if you aren’t familiar with the specificities, so let’s start with exactly that as we give a quick overview of one of the key metrics that investors look at when evaluating an investment: Net Working Capital (NWC).

 “Capital de Giro”

“Capital de giro” is the Portuguese phrase for Net Working Capital.  It translates into something like “capital used to make a business spin.”   Although strange at first glance, this quite literal translation isn’t too bad in summarizing exactly how NWC should be viewed within a business.  Essentially, it is the money that is needed to make a company tick day-to-day.  It supports all of the operating activities of a business – getting material from your suppliers, paying your employees to transform those materials into finished inventory or perform other services, and selling your goods and services to customers.  NWC is the money invested throughout the entire production and sales cycle, and its degree of importance will vary depending on your company’s industry.  For example, if a business produces a very complex product that takes an average of 180 days to complete, it’s going to have a much larger NWC than, say, a chain restaurant such as Chipotle which makes its burritos on the spot and is paid immediately by its customers.   NWC is the money that a business needs to invest in its products before actually receiving cash for those products.

(Important note: NWC should solely reflect the need for the company’s own cash – if a business can delay the payment of suppliers, this would effectively be a short-term source of cash for the company and would reduce the need to invest in NWC).

“Debt Free, Cash Free” and the Accounting Definition

As previously mentioned, any NWC analysis aims to understand the normal, recurring operating activities of a business.  This means that, for purposes of a merger or acquisition, all debt and cash on the balance sheet should be ignored in its calculation.  Why?  Typically, businesses are sold and valued on a “debt-free, cash-free” basis because (i) the amount of debt and cash that a company has is a result of capital structure decisions and not the company’s actual business activities, and (ii) if a company is bought, the previous owners have the right to any excess cash in the business and the obligation to pay any remaining loans or other financial debts (because, after all, it was their decision to take those loans).  This simplifies things in the calculation of NWC, especially if a company has a reliable set of financial statements, and leaves us with the following formula:

(1) Accounts Receivable from customers

+ (2) Complete and incomplete Inventory

+ (3) Other Prepaid Expenses (rent, insurance, etc.)

− (4) Accounts Payable to suppliers or service providers

− (5) Other Accrued Expenses (salaries, benefits, etc.) that have been earned but not paid to employees

 = Net Working Capital

Average Net Working Capital and Purchase Price

When investors make an offer to acquire all or a portion of your business, it is helpful to know that they make a key assumption regarding Net Working Capital: that the NWC at the time of closing is equal to the “normal” NWC of the business (usually based on some historical average).

A company’s NWC supports its day-to-day activities and is required to generate the sales, profits and eventually cash of a business.  For example, often times business owners will say, “My company has an EBITDA of $5 million.  Invest based off of that number, and oh by the way, I also have $5 million invested in inventory and another $5 million of accounts receivable that you are going to have to buy.”  Presuming that this inventory and accounts receivable are at normal levels when compared with the past (i.e. you don’t have a bunch of excess inventory that you bought for a special occasion), this $10 million of NWC is necessary to generate that $5 million of EBITDA, and therefore any purchase price based off of that EBITDA intrinsically accounts for the NWC of your business.  It’s not as if investors are going to be able to make money off of Net Working Capital because any new sales will follow the same historical patterns of the business, and the same investment in NWC will be required (i.e. if sales stay at the same level, for example, they will also have an inventory and accounts receivable of $10 million).

So, although NWC can be seen as inventory that owners have invested money into and, in the case of accounts receivable, sales that have already occurred that they have a right to, it is an inherent characteristic of a business and is taken into account when any offer is made.  If the NWC at the time of closing an investment differs from the agreed upon normal NWC, investors or business owners may have to pay the difference, depending on if it is higher or lower than expected.  To cap our explanation off with some numbers: if an investor offered you $30 million for your $5 million EBITDA business, and it was determined that $10 million was indeed the historical average NWC,  a closing NWC of $12 million would mean that the business owner would receive an additional $2 million, or $32 million in total.

For further discussion, we found the explanation at the law firm Gould & Ratner very helpful, which goes into detail about each item of NWC and its use in mergers and acquisition transactions.  Investing School gives a good overview for thinking about NWC outside of M&A transactions.  Also feel free to visit MergerBuddy to find out more about our service for middle-market business owners looking to sell or recapitalize their company.

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MergerBuddy is the first confidential online platform to actively match middle-market businesses (annual sales greater than $2 million) with potential investors based on levels of compatibility that go deeper than any other financing or sales process. Using its extensive database of investor preferences, obtained through the use of detailed questionnaires with over 30 categories of compatibility, MergerBuddy's online platform puts you in contact with potential accredited investors and partners that are truly interested in your exact business and not just your general industry or size. This innovative approach to mergers and acquisitions eliminates the significant wasted time and effort of talking with incompatible investors that is typical of traditional, outdated methods of selling a business while saving business owners millions of dollars.

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