A Practical Approach to Setting Net Working Capital Targets
Net working capital (NWC) adjustments may be one of the most misunderstood elements of a business sale and negotiations over it can often stall or kill a deal. In a previous, two-part blog series (click to read parts one and two), we discussed the rationale for NWC adjustments and their impact on the transaction. This week, we will look at some practical considerations for setting a NWC target when the monthly financial information is less than perfect.
Typically, the NWC target is based on the monthly average historical NWC over a 12-month period. In an ideal world, the target company has a robust monthly accounting process with proper month-end cut-offs and adjustments; however, in our experience, this is rarely the case when it comes to private companies. So, in the absence of reliable monthly information, how do you set the NWC target?
In this situation, understanding the business cycle and accounting processes is key. Here are some practical considerations for determining common elements of NWC:
Most private companies will accurately record sales invoices and cash receipts, meaning monthly receivables are usually accurate. A quick sanity check can be performed by calculating turnover ratio to see if the days in A/R make sense based on the Company’s credit policy.
In most cases, inventory will be the least accurate NWC item. Accounting processes vary widely from company-to-company. Some companies record all purchases directly to cost of sales, with an inventory adjustment only at year-end, while other companies attempt to correctly track inventory movements throughout the year, but only reconcile to an actual inventory count at year-end. There are also those companies that have random adjustments to inventory throughout the year without any apparent rationale. Assuming the annual gross margin is accurate (inventory adjustment is made at year-end), one possible option is to adjust cost of sales for a consistent monthly gross margin, with the offsetting adjustment being to inventory.
Like inventory, accounting processes for prepaid expenses vary widely; although, the balance is usually immaterial for most companies. There will generally only be a handful of big-ticket prepaid items (e.g., property tax, annual licenses), so the prepaid components of those items can be easily recalculated.
Similar to accounts receivable, most private companies will accurately record supplier invoices and cash payments, so monthly trade payables are mostly accurate. A review of the turnover ratio can be a quick check to see if the monthly balances make sense.
ACCRUED LIABILITIES (INCLUDING PAYROLL)
It is common for private companies to only adjust accruals at year-end. For many businesses, actual accruals do not vary significantly from month-to-month. If there are material fluctuations, those items can usually be specifically identified and recalculated.
For businesses with a significant unearned revenue component, the negotiations over its treatment can be complicated. We will have a future blog post dedicated to this specific topic – stay tuned.
Always keep in mind that the NWC target is a negotiation. As with every negotiation, there is no right or wrong answer. To get a deal done, practicality is more important than precision. Ultimately, it will come down to give and take between the parties as they evaluate the overall deal.