This is a guest post from my friend Chris Barrett, the best CPA I've worked with. Give him a follow on X and check out his website.

Business acquisitions often fail due to confusion and misunderstanding around one topic: net working capital (NWC).

But unfortunately few understand how to calculate net working capital.

And it often gets lost in the shuffle of buying a business.

In this guide, we’ll explore:

• Why NWC matters
• How to calculate NWC
• What to consider during the due diligence process.

Let's get into.

Why Does Calculating Net Working Capital Matter?

When buying a business, you’re purchasing a collection of assets expected to generate future cash flow.

One of those key assets is net working capital.

If the seller delivers the business with insufficient working capital, the buyer must inject additional funds to cover operational needs, which essentially increases the overall purchase price.

To avoid overpaying for a business, the purchase price should reflect a normalized level of NWC, ensuring the business has enough liquidity to continue operations without requiring immediate additional investment from the buyer.

How Is Net Working Capital Calculated?

Net working capital is calculated using the following formula:

Net Working Capital (NWC)=Current Assets−Current Liabilities\text{Net Working Capital (NWC)} = \text{Current Assets} – \text{Current Liabilities}Net Working Capital (NWC)=Current Assets−Current Liabilities

(It looks complicated - but it's easy if you use a spreadsheet).

This formula provides a snapshot of the business’s short-term financial health. However, a simple calculation isn’t enough. To calculate a normalized level of NWC, you must consider several factors to ensure it reflects the business’s true operational needs.

A normalized NWC represents the amount of working capital the business has typically required over a period of time, taking into account seasonality, growth, and other operational trends.

Make sure you're not buying a business that will need a NWC injection in a few months!

Types of Adjustments in Calculating Net Working Capital

When calculating net working capital for a business acquisition, you make adjustments to represent a normalized level of NWC. These adjustments fall into three main categories:

(1) Definitional Adjustments

Definitional adjustments specify which items to include or exclude in most cash-free, debt-free transactions. Understanding what belongs in NWC is critical for making accurate calculations.

Generally Included:

• Accounts receivable
• Inventory
• Prepaid expenses
• Accounts payable
• Accrued salaries and wages

Generally Excluded:

• Cash
• Debt
• Debt-like items
• Investment accounts
• Unearned revenue
• Old accounts receivable or obsolete inventory

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(2) Due Diligence Adjustments

During due diligence, adjustments are made to reflect non-operating or non-recurring items, as well as differences in accounting methods. These can significantly impact the NWC calculation.

Engaging in discussions with management and performing a detailed analysis of the financials is crucial for identifying these necessary adjustments. Due diligence helps ensure that the buyer is not inheriting unexpected liabilities or overvaluing certain assets.

(3) Pro Forma Adjustments

Pro forma adjustments account for recent changes in the business that don’t fully appear in the historical financials. For example, if the company recently extended its payment terms from net 30 to net 45, you must reflect this change in the NWC calculation to show its true impact on cash flow over time.

How to Set the NWC Peg

A common practice in business acquisitions is to establish a peg for net working capital based on historical data. Typically, you use a 12-month average of NWC to set this peg, but in certain cases, you may choose a different timeframe.

• For fast-growing companies, where working capital needs are increasing, a 3-6 month average may be more suitable.
• In highly seasonal businesses, you may choose to exclude slower months or give them less weight in the calculation to arrive at a more accurate reflection of operational needs. The goal is to establish a fair baseline to help both the buyer and seller understand the level of working capital transferred during the sale.

How Is Net Working Capital Handled in a Transaction?

Handling NWC in a transaction can vary depending on the size and complexity of the deal. Here are three common ways it’s managed:

No NWC, Adjust Purchase Price

In smaller transactions, particularly when the seller doesn’t fully understand NWC, it may be easiest to exclude NWC from the transaction altogether. In this case, you’ll need to adjust the purchase price accordingly.

For example, if the enterprise value is $2 million and the business requires $500k in NWC, the purchase price would be reduced to $1.5 million. The buyer would then inject their own working capital post-acquisition, either through equity contributions or a bank loan.

Leave NWC in the Form of Current Assets

In deals where the seller agrees to leave some working capital in the business, you can negotiate for them to include current assets like accounts receivable, inventory, or even some cash. The simpler the negotiation, the better.

Post-Closing Adjustment

In larger transactions, a post-closing adjustment might be used. At closing, an estimated NWC is provided, and a few months later, the actual NWC is calculated. A true-up occurs to adjust the final purchase price based on the difference between the estimated and actual NWC.

It’s worth noting that this method is typically used in larger deals and is generally not allowed in smaller business acquisitions funded by SBA loans.

The Role of Quality of Earnings (QoE) Reports

Working capital components in acquisitions An important part of any Quality of Earnings (QoE) report is the analysis of net working capital. A thorough QoE will:

• Summarize historical NWC to help set the peg
• Identify periods of potential cash crunches where a line of credit may be necessary
• Adjust NWC to remove any debt-like items or non-recurring assets

By understanding how NWC is calculated and the various adjustments required, buyers and sellers can approach negotiations with greater confidence. Whether you’re setting the peg or managing adjustments, accurate NWC calculations lead to smoother transactions and better outcomes for all parties involved.

Contact a due diligence professional at Midwest CPA to get help with your next acquisition, or email Chris directly at chris@midwest.cpa

Chris Barrett

Midwest CPA

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A message from Matthias:

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Disclaimer: The information in this newsletter is for informational purposes only and should not be considered legal or financial advice. Business buyers are encouraged to consult with their legal counsel and accountant to ensure the proper structuring of their transactions and to fully understand the tax implications of seller financing.

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