08 Jul Target Working Capital in Business Valuations
Written By: Mia Carley
(5-7 minute read)
A company’s working capital is calculated by subtracting current assets from current liabilities as reported on its balance sheet. This calculation indicates a company’s ability to service short-term debt used in ongoing operations. Within the context of business valuation, the structure of a proposed purchase may include target working capital comprising certain assets and liabilities of a company to support its ongoing operations following a sale.
The particular assets and liabilities included within a target working capital calculation can vary depending on the structure of a transaction, as can the amount of target working capital to be included. It is important for an appraiser to obtain clarification regarding the specific assets and liabilities that will be included in the calculation of target working capital, and, if applicable, the estimated amount or allocation of target working capital to be included within the purchase price. The business valuation should mirror the structure of the transaction. The net value of the current assets and liabilities that comprise target working capital will be included within the company’s final value.
The following examples illustrate different situations in which a proposed transaction includes target working capital and how an appraiser accounts for target working capital within the final adjusted book value.
Example #1 – Net Working Capital – no target amount determined
In the following example, the proposed transaction includes only fixed assets, net working capital, and goodwill. The net working capital calculation has been defined as “current assets (including only accounts receivable, inventory, and prepaid expenses) less current liabilities (including only accounts payable, payroll liabilities, and credit cards).” A target amount of net working capital has not been determined; therefore, the appraiser should include the full balances as reported on the interim balance sheet. The balance of net working capital included in the final adjusted book value is $135,000.
Example #2 –Target Net Working Capital Allocation – target amount determined
In the following example, the proposed transaction includes only fixed assets, target net working capital of $75,000, and goodwill. The target net working capital calculation has been defined as “current assets (including only cash, accounts receivable, and inventory) less current liabilities (including only accounts payable).” The proposed purchase price includes a target net working capital allocation of $75,000. The net balance of Cash, Accounts Receivable, and Inventory net of Accounts Payable exceeds the allocation of $75,000. Typically, when there is excess working capital that will be transferred to the buyer, there is an upward adjustment to the proposed purchase price. Therefore, an appraiser should only include the target working capital amount so the lender can compare the business valuation to the proposed purchase price, similar to the concept of “comparing apples to apples”. In this scenario, the appraiser will include a partial Cash balance of $15,000 in the final adjusted book value. The balance of net working capital included in the final adjusted book value is $75,000, which is equivalent to the target working capital balance included in the purchase price.
Example #3 –Target Working Capital Allocation and Shortfall
In the following example, the proposed transaction includes only fixed assets, target working capital of $50,000 and goodwill. The target working capital calculation has been defined as “current assets (including only cash, accounts receivable, and prepaid expenses) less current liabilities (including only accounts payable, payroll liabilities, and credit cards).” The balance of Cash, Accounts Receivable, and Prepaid Expenses net of Accounts Payable, Payroll Liabilities and Credit Cards is $15,000, which is lower than the target net working capital amount of $50,000. Typically, if there is a shortfall in working capital, as compared to the proposed purchase price, there would be a downward adjustment to the proposed purchase price. Unlike the example above, the appraiser cannot include partial liabilities in the final value so that the target working capital included in the final value matches the proposed purchase price, as a buyer would have to satisfy the full level of the liabilities. Therefore, the appraiser will include the assets and liabilities stated to be included in the working capital calculation and note a target working capital shortfall of $35,000, and this should be noted within the business valuation.
An appraiser should have a clear understanding of the current assets and liabilities that are included in the calculation of target working capital, and, if applicable, the estimated amount of target working capital to be included. Any disparity between the target or intended working capital balances and a company’s actual recorded balances will impact the amount of net working capital included in the final value. Additionally, it should be noted that a working capital shortfall and the resulting impact on the final value of a company may factor into a lender’s decision.