Thoughts on a fair working capital ratio for APA

intermediary profile

July 19, 2023

by an intermediary from Ohio State University in Fort Worth, TX, USA

For all my broker colleagues, trying to come up with a current market working capital ratio for my seller. and the APA. Thinking 1.2x to 1.3x is reasonable. What are people seeing these days?



Thanks Much!

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commentor profile
Reply by an intermediary
from The University of Chicago in Chicago, IL, USA
1. I have taught WC for 15+ years for M&A deals to I-bankers, CPAs, attorneys, PEGs etc. I also consult on WC when deals fall apart. At IBBA we are working for a series of courses on WC for brokers.
2. I have never run into WCR in my 35 years of M&A. It is the worst approach one can take. Seller can easily screw the buyer. Seller will be at a serious disadvantage if AP shoots up. WCP (WC peg) is the correct approach.
3. M&A WC definition (i.e. transaction WC) is different than accounting definition of WC. For M&A, WC, in simplest form, is AR + Inv-AP. (the primary components). It excludes cash, but not always. It excludes debt bit not debt-type. And there are exceptions to the 3 primary components as to whether all AR, Inv and AP are included. Also, one needs to address Accrued liabilities; this depends on what is accrued and the inventory costing system.
4. Establishing WC Target (aka WCP) is for the protection of both the buyer and the seller. WC Target removes seller motivations to manage WC, it protects seller for payment delays, and it assures seller gets all the profit till the date of closing.
5. Once you define WC, the common approach for WC Target is TTM average. The duration is shorter for growth or longer in certain situations. Seasonality is more complex, but TTM works in most seasonal situation.
6. Buyer DOES NOT get "additional" WC for a growing business. Buyer has to fund the growth. However, from a lender perspective, buyer needs a facility in place to fund growing WC.
7. There are other factors like accounting policy, cut-offs, sales distribution during the month, etc.
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Reply by a searcher
from Johns Hopkins University in Atlanta, GA, USA
I think it's helpful to ensure a "prudent reserve." I define that as a minimum of three months expenses on hand in cash or cash equivalents, assuming zero revenue - and I prefer 6 months. Setting that philosophy aside, I'm unclear on what you're asking, and agree with many of the above statements. There is so much confusion on NWC, clarity is essential. I think of it simply as the cash the business consumes as part of normal operations. So, if you're asking to calculate the NWC requirements then multiply that amount by something to provide safety for the buyer in operating the business after close, then 1.3 is probably a reasonable rule of thumb across a large number of businesses. BUT it depends...for instance, when you say NWC, are you using CA-CL (wide definition) or AR + Inventory - AP (restrictive definition) or some other formula? How are you handling the potential for bad debt (what's your ADA look like)? What is the discount factor (risk rate) and how are you calculating DSOs (when does the cash actually move/appear)? By "current market" I'm assuming you mean the market value of the NWC? I can't see how you can get to a fair value for this without a risk adjusted DCF model of the respective cash flows (on a weekly or daily basis, depending). Then your calculation is merely the PV of the calculated value(s) of the cash flows over the next period (which, again, depends on the formula used to calculate NWC). I *think* (meaning this is what I do) you need to separate the economic engine purchase price completely from working capital calculations and handle it that way.
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