Why is Working Capital calculation important during a business sale?

Andy Denny

When a buyer prepares an initial offer within a sale process, they will initially assess the Enterprise Value (EV) of the business, which can be derived from a number of different valuation methods. These can include assessing the Discounted future Cash Flows (DCF) of the target business, or using market multiples of sustainable EBITDA. In either case, EV assumes the business will transfer with sufficient assets to continue to produce the EBITDA used to derive value.

Assessing fixed assets in this context is relatively straightforward, providing the assets are well invested or regularly maintained. Working Capital (calculated as net current assets less cash, less debt) is considered more important as it has a direct impact on the liquidity of the business. As part of a transaction, a buyer and seller would agree on a target level of Working Capital to be available in the business at completion.

Setting a Working Capital target

The target can be set in several different ways, but will ultimately represent a required or normal level of Working Capital required for the business to operate as a going concern. Assuming the business is on a relatively steady growth path, then an average of the last 12 months’ working capital of the business would likely be acceptable as a target. If the business growth rate had increased in recent months – and that trend was expected to continue – it may be more appropriate to look at a more recent average to reflect the needs of the business moving forward.

In the month of completion, your actual working capital that month will be compared to the target working capital and an adjustment will be made. If your actual working capital is higher than the target, then an upward adjustment to EV will be made. If it is lower, then a downward adjustment will be made.

As shareholders, it is the Equity Value you are ultimately interested in

In addition to adjusting for working capital, EV is also subject to adjustment by the value of any cash or debt you have in the business at completion. If you have more cash than debt, then it will be an upwards adjustment. If more debt than cash, then it will be a downwards adjustment.

As shareholders, it is your Equity Value that you are ultimately interested in, as this will represent the value you will receive for your shares. To arrive at Equity Value, Enterprise Value will be adjusted upwards or downwards on a pound for pound basis by the level of cash or debt in the business, along with any working capital adjustment required.

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