Simply put, working capital is money that an organization uses to trade its daily operations. It’s a good indicator of the current health and financial position of the business. Working Capital is a measurement of liquidity. and By the difference obtained after subtracting the current liabilities from the current assets you will calculate working capital. The working capital is important because it is directly related to the cash flow of the organization.
Working capital, although it’s an essential component of exit strategies, is sometimes overlooked in the context of potential transactions. Sellers and buyers are not always aware of the importance 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.
Work Capital: How Important is it?
Work capital helps to fund short-term commitments and operations. Companies require working capital to cover their daily expenses, pay for unexpected costs and acquire basic supplies needed in the production of products. 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. The seasonality of revenue and the challenges it presents can all be addressed with sufficient working capital. This will increase the company’s value and be a benefit to the buyers. It will protect them from any working capital shortfalls with due diligence.
A company with positive working capital can prepare itself for the future without taking out new debt. Positive working capital helps companies maintain a good reputation on the market and makes it easier to contract.
How does working capital impact pricing?
Understanding how pricing is affected by working capital requires that we identify the ways analysts value it. Analysts use three types of value determination methods:
- Income approach which takes future cash flows into consideration
- Market approach to determining the selling price for similar businesses
- The asset approach, where assets and liabilities are considered.
Working capital is a valuable reference to an analyst in these types of procedures. Analysts might adjust the working capital needed to fund the expected growth of the company when following the income approach. The analyst might determine the excess or decrease in working capital by comparing it to 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.
Deals with Working Capital
Working Capital is often the source of dispute during transactions. Buyers and sellers need to negotiate how working capital will be handled at the beginning stages. Conflicts can be caused by the lack of a defined target amount and the exclusions or inclusions.
Because of the seasonality and fluctuation in income and expenses, the working capital levels will continue to fluctuate through the year. The net working capital could suffer from one problem item that is not identified. Or the asset’s value might be underestimated. Closing estimated working capital is what will affect the purchase price at closing because the business continues to operate throughout the transaction. After closing a phase – The true-up phase takes place which is another source of conflict. The net working capital balance must be compared to the actual. There are many reasons for disagreement regarding specific balance sheet accounts and their values.
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. To help your business grow, you should have realistic expectations about the future working capital.
How important is working capital when negotiating a deal? Entrepreneurship Life first published this post.