The Buy-Side Evaluation of Net Working Capital

as seen in Crain’s Cleveland Business, Jan. 21, 2019

In a business acquisition, the buyer should receive sufficient net working capital (“NWC”) to operate the business in its ordinary course. The assessment and negotiation of NWC is important; however, it can be challenging due to numerous factors. For example, is the seller experiencing rapid growth? Are there changes in payment terms with key customers or vendors? Are there issues with inventory costing practices?

NWC is commonly defined as (a) current assets excluding cash, less (b) current liabilities excluding debt. Depending on the industry, tax structure and composition of the seller’s balance sheet, there can be many accounts that should be excluded from NWC, such as:

• Owner discretionary items
• Extended / out-of-trade terms receivables
• Other non-operating current assets, such as unusual prepaid expenses
• Prepaid and accrued income taxes
• Deferred income tax assets and liabilities
• Extended / out-of-trade terms payables
• Equipment purchases within accounts payable
• Non-operating accrued expenses
• Customer deposits
• Deferred revenue
• Transaction-related balances

Oftentimes, the buyer’s analysis of NWC leads to the identification of debt-like obligations. These liabilities – either on or off the seller’s balance sheet – could represent additional financial obligations for the buyer if not properly identified and negotiated. Debt-like obligations represent further reductions from a seller’s enterprise value. The buyer would request such liabilities be excluded from the deal or be treated as a purchase price reduction.

Typical debt-like obligations include:

• Accrued income taxes
• Income tax exposures from improper deductions, elections, credits, etc.
• Extended / out-of-trade terms payables
• Outstanding checks
• Capital lease obligations
• Unrecorded incentive compensation
• Employee severance liabilities
• Customer deposits
• Deferred revenue
• Accruals for self-insured medical plans
• Contingent earn-out from a prior business acquisition
• Unfunded and unrecorded benefit plan obligations
• Unrecorded environmental clean-up liabilities

We are here to help buyers identify these items and ensure the purchase agreement is adequately constructed to define such liabilities.