Understanding Net Working Capital in M&A Transactions

Net Working Capital (NWC) is one of the most important—and most misunderstood—elements in a mergers and acquisitions (M&A) transaction. For both buyers and sellers, properly calculating and negotiating working capital can significantly affect the final deal value. Whether you’re preparing to sell your business or evaluating a potential acquisition, understanding the role of NWC is essential to a successful transaction.

What Is Net Working Capital?

In simple terms, net working capital is the difference between a company’s short-term assets and short-term liabilities:

Net Working Capital = Current Assets – Current Liabilities

In an M&A deal, NWC serves as a measure of the capital needed to keep the business running day-to-day. It includes accounts receivable, inventory, accounts payable, and other operational items. Importantly, it excludes cash and debt, which are typically handled separately in a cash-free, debt-free transaction structure.

Why Net Working Capital Matters in a Business Sale

When a company is sold, the buyer expects it to come with a normalized level of working capital—enough to operate the business without immediately injecting more funds. If the actual NWC delivered at closing is below the agreed-upon target, the buyer may receive a price reduction. If it’s above, the seller may receive an additional payment.

That means net working capital is a direct driver of the final purchase price.

For sellers, this can lead to surprises if working capital hasn’t been carefully managed in the months leading up to the sale. For buyers, it’s a key area of financial diligence and negotiation.

Common Challenges in Net Working Capital Calculations

Working capital sounds straightforward, but there are several factors that make it complex in real-world M&A transactions:

1. Setting a Realistic Target NWC

The target working capital is usually based on a 12-month average of historical NWC. However, this can be misleading if the business is seasonal, growing, or recently restructured. A company in expansion mode might have higher receivables and inventory, which should be considered when setting the baseline.

Tip: Adjust for seasonality, one-time events, or business cycles when determining the NWC target.

2. Inconsistent Financial Reporting

In the lower middle market, many businesses lack audited financials or consistent accounting methods. Items may be misclassified or inconsistently booked, leading to confusion about what’s actually included in working capital.

Solution: A thorough quality of earnings (QoE) review helps clarify and normalize working capital metrics.

3. Disagreements Over Specific Items

Items like prepaid expenses, customer deposits, accrued bonuses, and deferred revenue often spark debate. Should deferred revenue be included as a liability? Should customer deposits offset accounts receivable?

Best Practice: Define each NWC component in the purchase agreement to avoid post-close disputes.

4. Inventory Valuation

Inventory is a major part of working capital in many businesses, especially in manufacturing, distribution, and retail. If inventory is outdated or overvalued, the buyer may adjust the working capital downward, lowering the purchase price.

Recommendation: Conduct a full inventory audit and remove slow-moving or obsolete stock from the calculation.

5. Post-Close Adjustments

After the deal closes, the buyer and seller typically have 30–90 days to finalize the actual working capital delivered. This process—known as the working capital true-up—can result in a payment from one party to the other based on how the final NWC compares to the target.

How to Prepare for Working Capital Negotiations

To avoid surprises and protect your deal value, both sellers and buyers should take a proactive approach to NWC:

• Start early: Begin working capital analysis during the LOI (Letter of Intent) stage.

• Use detailed schedules: Break down assets and liabilities to identify unusual fluctuations.

• Align accounting policies: Ensure the definitions in the APA (Asset Purchase Agreement) match actual accounting practices.

• Get professional support: Use an experienced M&A advisor and a third-party financial firm for QoE analysis.

  
  

Final Thoughts

Net working capital plays a critical role in mergers and acquisitions. It’s more than just an accounting number—it’s a key value lever in your transaction. Sellers should work closely with their advisors to manage working capital in the lead-up to a sale. Buyers must carefully analyze and negotiate it during due diligence.

Need guidance on preparing your business for sale or evaluating a target?

Contact us today to schedule a confidential consultation on your business value and NWC.