Working Capital Adjustments – Why and How?

In the accounting world, working capital is defined as current assets minus current liabilities. Businesses need a minimum amount of working capital to be able to pay employees, buy inventory and maintain their normal day-to-day operations.

A working capital adjustment is a common element that is included in most business purchase agreements. The working capital adjustment provides for an adjustment to the purchase price for any increases or decreases from a predetermined working capital amount (called the working capital target) as compared to the working capital amount at closing (called closing working capital).   The purpose of a working capital adjustment is to protect the buyer so that the seller does not manipulate the operations between the time of the signing of the purchase agreement and closing by taking out all the working capital before the seller hands the business to the buyer.  An example of this manipulation would be for the seller to collect accounts receivable and delay the payment of accounts payable then using the increase in available cash to make a significant distribution before the sale is closed.

The concept of a working capital target sounds pretty simple, but how do we determine or even define the proper working capital amount?

1. What accounting method should be applied to determine the working capital target and at closing?

   1. U.S. GAAP – this allows for uniform accounting practices that are “generally accepted”.

   2. Accounting principles consistently applied – this allows for an “apples to apples” comparison at each measurement date.

2. What is the measurement period to determine an accurate working capital target for the business?

   1. 12 months – a full-year average would “smooth out” unusual monthly fluctuations or seasonality.

   2. Industry standards – could incorporate business uniformity and normalized balances.

   3. Another period of time that reflects the turnover of working capital  accounts may make sense.

3. How are estimates treated that are imbedded in the working capital accounts?

   1. The seller may want to be less conservative and minimize reserve amounts to reduce the impact of non-deductible tax items.

   2. The buyer may want to be more conservative and have higher reserves (contra-assets) so the buyer does not get hurt by uncollectable receivables or inventory write-offs in the future.

4. How should customer deposits be treated in the determination of the working capital adjustment?

   1. Should this balance be treated the same way as any current liability?

   2. Or in a cash-free and debt-free deal, should this balance be treated as a dollar for dollar reduction of the purchase price so the buyer has the full benefit of the cash proceeds?

Obviously, this are no right or wrong answers. In many cases, the working capital target is a negotiated item or is based on the buyer’s expected amount of working capital needed to maintain the business’ revenues and cash flows.  Rather than approaching the topic with the assumption that what is “favorable to the buyer is unfavorable to the seller”, proper planning during the early stages of a transaction will eliminate many of the uncertainties or unexpected consequences and will help to avoid potential disputes over the working capital adjustment.

Please contact us with questions.