Working Capital is a Business Asset
It is a common occurrence that after speaking with owners about value they should expect to receive in a business transaction, they look at their balance sheet and attempt to add the value of their accounts receivable or inventory to their proceeds. Unfortunately, under most circumstances this is wrong.
Working capital is a business asset and not a personal asset. Since buyers of companies are typically acquiring a turn-key entity, that means that a buyer will expect a normal amount to be included in the sale price. The rationale is that the business cannot operate without working capital. If a buyer is required to bring additional capital into a business after the close, it reduces the return on equity and return on assets of the business. This is akin to a retail investor putting more and more money into a stock or a bond for smaller and smaller rates of return. At some point, there is opportunity cost and you will look for investments with a higher rate of return. This same concept applies to how buyers evaluate businesses.
Whereas the true definition of working capital is current assets minus current liabilities, in business transactions it typically refers to the cash conversion cycle that includes inventory, accounts receivable, and accounts payable. You can think of it this way. A distribution company takes cash and buys inventory. When buying the inventory, they also book accounts payable. Once the inventory is sold, it turns into accounts receivable. Upon receipt of the accounts receivable, the company pays off the accounts payable and then has cash to pay operating expenses and book a profit. The normal amount of working capital that allows the seller to book a historical amount of profit is what is typically expected to be included.
The longer it takes for a company to collect accounts receivable, the more working capital a company needs. Similarly, the faster vendors require payment, the more it sucks up the company’s cash. Of course, the opposite to both of these statements is true. Regarding inventory, if a company has the ability to drop ship to customers upon sale and does not need to fill up a warehouse, it reduces the capital strain on a business versus a company that needs inventory on hand in order to properly merchandise or ship orders on a timely basis. The big takeaway should be that business sellers are far better served operating the business in a way that reduces the working capital needs of the operation.
I know what you’re thinking. You’ve read articles or seen businesses posted where the buyer pays for inventory on top of the business price. While that may very well be true, in those instances the seller is paying off the accounts payable instead of using them in the working capital calculation so net net, the parties are ending up in the same place.
The most common scenario is that businesses are valued on a debt free, cash free basis. That means that once a transaction is closed, business owners will take the cash off the balance sheet and pay off the long term debt with the cash, utilizing the sales proceeds if necessary. Even in stock transactions whereby the buyer is acquiring the seller’s balance sheet, if a seller does not pay off its long term debt prior to the close, the buyer is adjusting its valuation downward by the amount of debt assumed or upward by the amount of cash it’s assuming above the working capital target.