Net Working Capital in a Transaction Context – Part Two

Welcome back! In our last post on net working capital (NWC) in a transaction context, we discussed what NWC is and why it matters in a transaction. We also introduced the idea that buyers will typically expect “sufficient” NWC to be delivered on closing. In this week’s post, we will dive into how this NWC level is determined and how it impacts sales proceeds.


Up to this point we have referred to a “sufficient” level of NWC that is expected to be delivered on closing. In the world of mergers & acquisitions, this is typically referred to as “normalized” NWC – that is, the level of NWC that is “normal” for a business.

Although there are many ways to determine normalized NWC, a robust analysis will include consideration of the following:

  • Seasonality – a business’ NWC levels will typically fluctuate throughout the year along with the seasonality of the business. For example, a retailer’s inventory levels will typically rise towards the end of the calendar year in anticipation of the holiday shopping season. The determination of normalized NWC should therefore consider average monthly levels over a lookback period, typically 12 months. It is best to avoid using a lookback period that includes a fraction of a year, such as 6 or 18 months, as this may include an unequal number of peaks and troughs that will distort the average.
  • Cyclicality – for businesses where earnings follow a cyclical pattern lasting more than one year, it may be appropriate to use a lookback period of 24 months or more to understand the long-term trend. However, it’s important to consider the level of earnings being used to arrive at the sale price and consider that in the NWC determination. For example, if a buyer is paying based on earnings at the peak of a cycle, then it is reasonable for them to desire a NWC level towards the higher end of the cyclical trend.
  • Future expectations – recall that normalized NWC is linked to the level of NWC that is required to run the business. If a buyer is paying a premium price that contemplates significant growth, it is likely that a higher level of NWC will be required to achieve this and normalized NWC may be at or above the upper end of historical levels. Conversely, if a buyer is paying a lower price based on stagnant growth or even decline, normalized NWC may be at or below the lower end of historical levels.

As normalized NWC is typically determined with reference to a historical period, which cannot be changed by the time a transaction is consummated, our third key recommendation of this series is:

Manage your NWC levels carefully several years in advance of a transaction to avoid leaving money on the table due to a history of excess balances.

In addition to the above considerations, it is likely that a business’ historical NWC accounts include specific items that should be adjusted in determining normalized NWC. These are referred to as:


In determining normalized NWC, it is important to identify and remove any unusual, non-recurring and non-operating amounts from the historical balances, as well as any amounts that would be excluded from the definition of NWC in the purchase and sale agreement. Although the specific adjustments will vary from business to business, those we most frequently observe include:

  • Aged accounts receivable – purchase and sale agreements typically exclude “old” accounts receivable, often those outstanding for more than 90 days, from the definition of NWC; to ensure consistency, monthly aged accounts receivable listings should be reviewed to remove old amounts from the historical balances.
  • Obsolete inventory – purchase and sale agreements also typically exclude obsolete, expired or otherwise unsellable inventory from the definition of NWC; again, to ensure consistency, monthly aged inventory listings should be reviewed to remove any such amounts from the historical balances.
  • Non-recurring accounts payable – a business’ accounts payable balances will often include non-recurring amounts, such as those related to capital expenditures, employee severance and professional fees related to disputes or even the sales process itself. Monthly accounts payable listings and accrual working papers should be reviewed to remove these amounts, as they do not reflect a normal level.
  • Related party amounts – many businesses engage in transactions with related parties that are either not in the normal course of business or are on payment terms that are not arm’s length. Related party receivables and payables that are not in the normal course of business are typically removed in arriving at normalized NWC. Those that are not at arm’s length terms should be restated to what would be expected post-transaction.
  • Journal entries – many businesses do not do full month-end closings, which may result in significant year-end adjusting journal entries, such as a true-up to a year-end inventory count. These entries should be reviewed to determine whether some or all of the adjustment relates to previous months.

Identifying NWC normalizing adjustments can be a time-consuming process, but it is generally worth the investment. Our fourth key recommendation of this series is:

Take the initiative to analyze your historical NWC levels and negotiate a normalized NWC level early in the transaction process, ideally before going exclusive with any one buyer.

This is because a vendor’s negotiating power typically falls later in a transaction process and, as mentioned, the agreed normalized NWC level will impact the sales proceeds. How does this work?


Although a full discussion of the treatment of NWC in a purchase and sale agreement is beyond the scope of this post, a fulsome agreement will typically include the following:

  • A definition of what is, and is not, included in NWC;
  • The normalized level of NWC agreed;
  • How the actual NWC delivered on closing will be calculated and a timeline for doing so; and
  • How the purchase price will be adjusted for any NWC surplus or deficit.

The NWC surplus or deficit is the difference between the NWC delivered on closing and the normalized level agreed. For example:

  • If $5 million in NWC is delivered and the normalized level is $4 million, there is a surplus of $1 million, which increases the purchase price;
  • If $5 million in NWC is delivered and the normalized level is $6 million, there is a deficit of $1 million, which decreases the purchase price.

Over this series we have discussed what NWC is, why it matters in a transaction, how it can be determined and how it impacts the purchase price. NWC can be a complex area of a transaction and having an experienced advisor to assist with the analysis and negotiations can help immensely. If you are in the process of selling your business or are contemplating selling in the future, please reach out to one of our transaction advisors for more information.