Why is Working Capital Important in a Business Sale Transaction?

The calculation of working capital requirements can be a little cumbersome, and as such it’s a topic that many business owners have a problem grasping. Working capital is the “blood” of a business and measures liquidity to indicate the company’s short-term health. It is the cash that the business must have on hand to pay its current liabilities. These include bills due in the next 30 to 60 days, such as rent, payroll, utilities, and more.

In an asset sale, the seller keeps all of their cash in the bank and all accounts receivables. At the time of the transaction, the seller will also pay off any business debts. When the buyer takes ownership, there is no cash left in the bank to pay the bills coming up in the next 30 to 60 days. The money (capital) needed to pay these bills is working capital. It is calculated by subtracting the current liabilities from assets.

How working capital is handled in a sale – options

  • The bank financing the deal includes the working capital amount in the loan total
  • The seller leaves enough cash in the bank for the buyer to use as working capital
  • The seller includes a portion of the accounts receivables for the buyer to use as working capital

Buyers and sellers may be looking at cash flow very differently. Buyers want as much liquidity in the business after the deal to operate, and sellers will want to pull out as much cash as possible before the sale closes. To complicate things further, some assets aren’t necessarily easy to evaluate, and related liabilities don’t always appear neatly on the balance sheet.

Buyers and sellers need guidance. An accountant or business analyst can calculate the net cash flows and make adjustments based on growth, industry trends, historical working capital levels, and competitors.

Negotiating Working Capital Terms

The buyer and seller must negotiate how working capital is treated in a transaction. By working with a Colorado Business Broker, you can avoid unnecessary disputes while setting your “Target Working Capital” for the sale/purchase. They will advise you on:

  • Seasonal revenue and expenses that fluctuate working capital levels throughout the year
  • Valuation methods for assets in different categories
  • Treatment of one-off items impacting working capital that won’t exist going forward

The business is operating throughout the transaction, and the estimated working capital will affect the purchase price on the date of closing. In the first few months after closing, an accountant brings the net working capital balance in line with the actual numbers. Called the true-up phase, it is a second potential source of conflict. Without pre-planning, disagreements often arise over specific balance sheet accounts, accounting methods, and what should be included or excluded from the calculation.

There are several ways business owners can maximize value and prevent problems in a transaction. A Colorado Business Broker can help them to improve the efficiency of working capital and turnover ratios before a sale. The turnover ratio is calculated by dividing sales by working capital to see how well your company uses its monthly cash flow.

Business owners should keep monthly records and analyze historical trends with working capital to avoid surprises during the sales process. In addition, buyers should project future working capital with realistic expectations about the investment in inventory required to run and grow the business.

Because working capital impacts value, it must be considered in a sale or purchase. Sellers can increase company value by managing cash flow levels, and buyers can protect themselves against working capital deficiency with awareness and proper due diligence.

Rocky Mountain Business Advisors is a business brokerage focused 100% on selling our clients’ business. As Business Brokers, we fathom it as our responsibility to apply a proven process to educate, prepare, and guide our clients through the sales process so that they can focus on managing their business while we focus on a successful sale. We bring a strong sense of urgency and tenacity to every engagement to realize the highest sales price in the shortest period of time. We bring buyers and sellers together. Contact us at 303-474-5582https://rockymountainba.com/ , or schedule a free 15-minute consultation to learn more about the services that makes us one of the best business brokers in Denver.