What is a Working Capital Adjustment: Everything You Need to Know
If you're wondering, "What is working capital adjustment," it's a type of purchase price adjustment seen in the acquisition of a company. 3 min read
If you're wondering, "What is working capital adjustment," it's a type of purchase price adjustment seen in the acquisition of a company. The company that is the object of a purchase, or target company, has working capital that's in a constant state of fluctuation. When a buyer is acquiring a company, the working capital adjustments protect them by preventing the seller from consuming the target company's working capital before closing the deal. Working capital adjustments also protect the seller by holding the buyer from getting an unexpected gain in capital if the working capital surges between the buyer's starting valuation date and the closing date.
What Is Working Capital?
Working capital, or net working capital, is the company's current assets (cash, accounts receivable, and inventories) less current liabilities (accounts payable), i.e., current assets – current liabilities = working capital. Working capital indicates a company's operational efficiency and its short-term financial state. In order to function, most businesses require a minimum amount of working capital.
The working capital ratio — which is current assets to current liabilities — determines if a company has sufficient short-term assets to offset its short-term debt. A preferred working capital ratio is anything between 1.2 and 2.0. Any rating less than 1.0 shows a negative working capital, with possible liquidity difficulties. A number over 2.0 suggests that a company isn't making use of its surplus assets efficiently to create the best potential returns.
When Does a Working Capital Adjustment Occur?
A working capital adjustment occurs when a seller doesn't provide the working capital designated by the buyer as part of the tangible asset backing required to finish the transaction. When a buyer evaluates a target company, they look at the average NOWC, or net operating working capital, that's needed to meet the present revenue levels, possibly requiring the seller to provide a particular net working capital amount along with the fair market value of capital assets to sustain the enterprise value — an economic measure that indicates the market value of a business — calculated for the business.
When figuring the working capital, sellers need to make sure that they add all their current assets to the amount. For instance, there are private companies that classify their supplies as expenses to get a faster tax write-off. Yet, supplies are also current assets when inventoried and included as part of the working capital to contribute to the sales transaction. Prepaid expenses anticipated for use throughout the year and allocated for that purpose should also be a part of the working capital.
Facts About Working Capital Adjustments
- The needed working capital is ordinarily determined during the letter of intent part of the transaction, and then becomes more clarified at the time the due diligence stage takes place. At the closing of the deal, if the working capital delivered is not at the right level, a working capital adjustment results.
- Working capital adjustments are customary in mergers and acquisitions. Sellers need to be aware of their real average NOWC to make sure the buyer doesn't overestimate the number. Buyers frequently employ a higher working capital point to warrant a declining adjustment to the purchase price.
- Working capital adjustments can occur at the closing date, but they are more likely happen three to four months after closing because the buyer usually needs this much time to have their auditors review the numbers. At that time, all the accounts would be inactive, so a final, more accurate working capital amount can be computed. A comparison between the final amount and the original working capital number becomes completed, which determines the adjustment.
- A buyer acquiring a target company needs to make certain the target company has efficient working capital after closing the deal to continue operations as previously conducted by the seller. If there is not enough working capital, the buyer needs to infuse more cash into the business, effectively increasing the purchase price it is paying.
Questions About Working Capital Adjustments
Working capital adjustments occur when a buyer purchases a target company, which benefits both the seller and buyer. If you want to learn more about working capital adjustments or you have any legal questions concerning working capital adjustments because you're buying a business, you may want to contact a lawyer.
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