Determining Working Capital Needs -- Prior to Making Offer

November 29, 2023

by a searcher in Cincinnati, OH, USA

The great debate is always whether working capital should be included or excluded.

For Buyers who EXCLUDE working capital from your transaction (thus avoiding the hassle of negotiating a w/c peg) -- how do you determine how much working capital is necessary (via Cash or a LOC) when penciling out your deal PRIOR to making your offer?

Just trying to determine how much will be necessary, so I can adjust my transaction multiple accordingly.

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Reply by a searcher
from Temple University

You can do the math...Ideally less than 60 days AR but industry-dependent....so (60/365)*annual revenue. Then for inventory, I'd probably use historical inventory levels as a % of annual COGS (or could also use revenue assuming relatively consistent gross margins). For AP you can go bottom up with contracts and projecting expenses, or top down with AP as a historical % of COGS+SG&A applied on a forward basis, and then back-test it against historical levels. Don't forget accrued expenses - typically salaries on a 2 week pay cycle if separate from AP.

You should also look at how net working capital (NWC) changes from quarter to quarter to make sure there's no one period of the year higher than another...For instance, if you were buying a Christmas lights manufacturer in August, you might under-project inventory cash requirements if using average annual NWC since most of the demand for cash comes in September-November getting prepped for Christmas. Check to see how NWC changes relative to revenues earned. If it's pretty consistent, then that should be a point of confidence, too. If it's not, ask the seller.

Reply by a searcher
from University of Victoria in Vancouver, BC, Canada

I've excluded it in the deal that I'm working on at the moment but have had a very open dialogue that it will need to be included and the seller is fine to recognize that at a high level for now. We've basically put a placeholder expectation in saying that buyer and seller's accountants to review monthly balance sheet over past 24 months to come up with target baseline working capital, which will be included in the offer and purchase price. We will do an adjustment at close that will look at the balance sheet then, if the working capital is greater than the baseline number, we will pay it out to them, if it is less, we will decrease the purchase price dollar for dollar by the gap.

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