Understanding Working Capital in M&A Transactions

Understanding Working Capital in M&A Transactions

Matt Gilbert

August 21, 2023

Owners of privately-held businesses in the lower middle market pour their hearts and souls into building their companies. Their dedication, hard work, and entrepreneurial spirit drive success. When these owners contemplate the possibility of selling the business or bringing in a financial partner, they are often filled with mixed emotions such as excitement about new opportunities and the potential for growth but also uncertainty of navigating the world of mergers and acquisitions.

While most business owners are familiar with the concept of working capital, they really need to understand its significance within the context of an M&A deal. It can be a game changer! Whether an owner is just beginning to explore the possibility of selling or has already taken the first steps toward an M&A transaction, we hope this blog will serve as a valuable resource for the journey. Our goal is to equip business owners with the tools needed to make well-informed decisions.

Understanding Working Capitalse

Working capital is a fundamental financial metric that represents the difference between a company's current assets and current liabilities. In simpler terms, it reflects the amount of money a company has available to cover its short-term operational needs. This includes aspects such as inventory, accounts receivable, accounts payable, and cash on hand.

For privately-held businesses, working capital is an essential indicator of a company's financial health and operational efficiency. Maintaining an optimal level of working capital ensures that a company can smoothly conduct its day-to-day operations without facing cash flow constraints.

The Role of Working Capital in M&A Transactions

When a privately-held business is preparing to enter into an M&A transaction, understanding its working capital is vital. Working capital plays a pivotal role in the valuation of a company. Potential buyers will analyze working capital to gauge how efficiently the company manages its short-term assets and liabilities. Well-managed working capital demonstrates a stable and robust business, while inadequate or poorly-managed working capital might raise concerns about the company's financial health.

Calculating Working Capital

Working Capital = Current Assets less Current Liabilities

Current Assets: Include cash and other assets that are expected to be converted into cash or used up within one year. Some common examples of current assets are:

• Cash and Cash Equivalents – cash in hand, bank accounts, and highly-liquid investments with a short-term maturity

• Accounts Receivable – money owed by customers for goods or services provided on credit

• Inventory – raw materials, work-in-progress, and finished goods held for production and sales

• Prepaid Expenses – expenses paid in advance, such as insurance premiums or rent

Current Liabilities: The company's obligations due within one year. Common examples are:

• Accounts Payable – the amount owed to suppliers for goods and services purchased on credit

• Short-term Debt – any loans or debts with a maturity of less than one year.

• Accrued Liabilities – expenses incurred but not yet paid, such as salaries or utilities

The Importance of an Accurate Working Capital Calculation

• Valuation Impact: Working capital directly influences a company's valuation. If a company has excess working capital, it can boost the overall valuation. On the other hand, a company with insufficient working capital might be undervalued as the buyer may account for the additional capital required to finance short-term operations.

• Negotiations: The working capital amount is subject to negotiation between buyer and seller. A well-prepared business owner, armed with a thorough understanding of their working capital, can confidently navigate these negotiations and secure more favorable deal terms.

• Smooth Transaction: By having a clear understanding of their working capital, business owners can address potential issues proactively and ensure a smoother transaction process since transparency and trust are essential.

3 Tips for Optimizing Working Capital BEFORE an M&A Transaction

Optimizing working capital before selling can enhance the attractiveness of a company to potential buyers and lead to a more favorable sale for business owners.

1) Efficient Inventory Management: Evaluate the inventory turnover ratio and ensure excess inventory is not being held. Efficient inventory management can free up cash that can be reinvested into the business or used to reduce debt.

2) Accounts Receivable Streamlining: Implement effective credit policies to minimize outstanding receivables. Promptly collect payments from customers to maintain a healthy cash flow.

3) Vendor Negotiations: Engage in constructive discussions with suppliers to negotiate favorable payment terms. This can help extend accounts payable and provide more time to manage short-term obligations.

As experienced M&A professionals, we understand the unique challenges lower middle market business owners face when entering a sale transaction. Each company occupies a distinct space within the marketplace and has characteristics that set it apart from larger enterprises. Our mission is to empower owners with knowledge and insights such as the role of working capital as discussed in this blog. Preparation and knowledge are the keys to securing the best possible outcome for a privately-held, lower middle market business sale or joint venture.

If any of this resonates with you, we encourage you to complete our M&A Discovery Questionnaire and talk with us to see if your business makes the cut as one who can still command a great exit in this M&A environment. We will be in touch quickly to discuss the results. Click here to take the assessment.

Gilbert & Pardue Transaction Advisors (GaP) is a Houston-based business advisory firm serving lower middle market business owners from coast to coast through representation for Mergers & Acquisitions (M&A).

Matt Gilbert and Bret Pardue established GaP to provide owners of lower middle and middle market businesses – those businesses generally enjoying annual revenue of $10-$80 million – with the quality of M&A representation and value-enhancement services previously only available to upper middle and large businesses. GaP brings highly experienced executives, sophisticated financial and marketing products, proven-effective processes, and fully-integrated expertise to every engagement. No other M&A firm serving the lower middle provides the quality of representation and transactional expertise that we do.

Join hundreds of other business leaders and owners in the know. We regularly share lower middle and middle market insights and educational content aimed at helping business owners plan and navigate successful exits or partnerships.

Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form