Working Capital in simple terms is the funds utilized in the day-to-day trading operations of an organization. It is an important indication of the short-term health of the company. Working Capital serves as a measure of liquidity. and By the difference obtained after subtracting the current liabilities from the current assets you will calculate working capital. Since the valuation of an organization is determined inherently by its cash flow and cash flow is impacted by the working capital, therefore, working capital plays a significant role.
However, despite being a vital component of the exit strategy, working capital is often overlooked when considering potential transactions. Buyers and sellers are often ignorant of the worth of working capital.
When a company doesn’t have sufficient funds or comes across a situation of emergency; availing of small business loans that have a less intensive process of application and quick deliverance of capital can save them from disarray.
Before we proceed with understanding how exactly working capital helps in a deal, let’s know the importance of working capital.
The Importance of Working Capital
Working capital can fund operations and help with carrying out short-term obligations. Working capital is required on a daily basis by businesses to make regular payments, cover unforeseen costs, and purchase basic materials used in product creation. Basically a company’s everyday operations rely on working capital. Working capital is a measure of a company’s operational efficiency and short-term financial stability. It can efficiently maintain an organization’s expenditure even through cash flow fluctuations. With adequate working capital, the seasonality and challenges in revenue can be tackled. This will not only boost the value of the company and prove advantageous for the sellers but will also benefit buyers by protecting them against working capital deficiency with proper due diligence.
A positive working capital helps a company to prepare for future expansion without acquiring new debt. A company with a positive working capital maintains a positive image and reputation in the market, making contracting easier.
How Does Working Capital Impacts Pricing?
To understand how working capital impacts pricing, we need to identify how analysts determine value. To determine value analysts usually employ three methods-
- An income approach that takes into account the future cash flows
- A market approach that reckons the selling price of similar companies
- An asset approach wherein the assets and liabilities of the company are considered
To carry out these procedures flawlessly, working capital serves as a great reference for an analyst. When pursuing the income approach, the analyst might make an adjustment for the increase in working capital that the company will need in order to fund its expected growth. In case of an excess or deficit of working capital, the analyst may find the sum or difference from the total equity. Looking at the trends in the organization’s past working capital, the analyst can easily determine these adjustments and also compare the working capital of competitive industries.
Working Capital in Deals
Working Capital often becomes the cause of disputes during transactions which is why buyers and sellers should negotiate at the initial stages how the working capital will be treated. Setting up a target working capital and defining the inclusions and exclusions are the origin of conflicts.
Working Capital levels are bound to keep fluctuating throughout the year due to the seasonality of revenue and expenses. There could be one faulty item impacting the net working capital immensely and it might not be identified or the value of assets might not be anticipated. Since the organization keeps functioning throughout the transaction process, the purchase price on the date of closing will be impacted by closing estimated working capital. After closing a phase – The true-up phase takes place which is another source of conflict. It involves a calculation where the net working capital balance is equated with the actual. Specific balance sheet accounts, their values, methods employed; inclusion or exclusion from the true-up calculation can be some sources of disagreement.
Since working capital is an important measure of liquidity and affects the organization’s efficiency and transactions, the management should maintain monthly records and study historical trends to avoid any surprises. Maintaining realistic expectations, the future working capital should be projected to help the business grow.