Key Takeaways

  • A working capital adjustment ensures the buyer receives a business with adequate short-term liquidity to continue operations post-closing and prevents unfair gains or losses due to fluctuations between signing and closing.
  • The target working capital is typically based on historical averages, seasonality, and the company’s operating cycle, and serves as a benchmark for post-closing adjustments.
  • Adjustments can increase or decrease the purchase price depending on whether actual working capital is above or below the target level.
  • Key negotiation points include how working capital is defined, which accounts are included, and whether any “normalized” adjustments are made for unusual items.
  • The adjustment process involves establishing the target, measuring actual working capital at closing, comparing the two, and settling the difference — often several months post-closing after final numbers are confirmed.

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.

Understanding Target Working Capital

In a merger or acquisition, parties typically negotiate a target working capital amount — a benchmark that represents the level of working capital needed for the company to operate normally after the deal closes. This figure is often calculated based on the average normalized working capital over the past 12 months, adjusted for known seasonal trends or extraordinary items.

For example, a company that requires higher inventory before a seasonal sales peak may have a higher working capital target to reflect that operational reality. On the other hand, one-time events like a major prepaid expense or a short-term spike in receivables are usually excluded from the calculation to avoid distorting the benchmark.

The agreed-upon target ensures the buyer does not overpay if working capital has been reduced prior to closing and that the seller receives fair value if working capital has been built up to support growth.

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. 

How the Working Capital Adjustment Works

A working capital adjustment typically follows this step-by-step process:

  1. Set the target: The buyer and seller negotiate the target working capital based on historical levels and the company’s ongoing needs.
  2. Measure at closing: The actual working capital on the closing date is calculated using agreed-upon accounting principles.
  3. Compare actual vs. target:
    • If actual working capital exceeds the target, the buyer pays the seller the difference, as the business is being transferred with extra liquidity.
    • If actual working capital is below the target, the purchase price is reduced to compensate the buyer for the additional capital they must inject.
  4. Post-closing adjustments: Final figures are often determined 60–120 days after closing, once audited financials are available.

This mechanism protects both sides: buyers avoid unexpected cash injections to keep the business running, and sellers are fairly compensated if they deliver a company with surplus 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.

Negotiation Considerations and Best Practices

Because working capital adjustments directly affect the final purchase price, negotiations around them are often intense. Some best practices and key considerations include:

  • Defining working capital precisely: Parties must agree on which accounts to include. Items like deferred revenue, income taxes payable, or unusual accruals may or may not be included depending on the nature of the business.
  • Normalizing historical data: Removing one-off items (e.g., unusually large receivables or prepaid expenses) ensures the target reflects a realistic, ongoing level of working capital.
  • Addressing seasonality: Businesses with cyclical sales should use multi-year averages or season-adjusted calculations.
  • Establishing dispute mechanisms: Purchase agreements often outline procedures for resolving disagreements on post-closing adjustments, including third-party accountants or arbitration.

Clear definitions and careful negotiation at the outset help avoid disputes and surprises once the adjustment process begins.

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.

Real-World Examples of Working Capital Adjustments

A buyer agrees to purchase a company with a target working capital of $10 million. At closing, actual working capital is $8 million. Because the business is short $2 million in liquidity, the buyer reduces the purchase price by $2 million or requires the seller to fund the shortfall.

Example 2 – Above Target: In another deal, the target is $12 million, but actual working capital is $14 million. The buyer pays the seller an additional $2 million since the company is being delivered with more than the expected operating liquidity.

These examples illustrate how working capital adjustments keep transactions fair and aligned with the financial reality of the business being acquired.

Frequently Asked Questions

  1. Why is a working capital adjustment necessary in a deal?
    It ensures the buyer receives a business with adequate liquidity to operate post-closing and prevents either party from gaining or losing value due to pre-closing changes.
  2. How is target working capital calculated?
    It’s usually based on historical averages adjusted for seasonality, one-time events, and the company’s operational needs.
  3. What happens if actual working capital is below the target?
    The purchase price is reduced or the seller must provide additional funds to cover the shortfall.
  4. Are working capital adjustments always settled at closing?
    Not always. Final adjustments are often made 60–120 days after closing, once audited financials are complete.
  5. Can working capital adjustments be disputed?
    Yes. Disputes often arise over definitions or calculations. Agreements typically include resolution mechanisms, such as appointing a neutral accountant.

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