Calculating Working Capital in M&A Transactions
The working capital is the business capital used in daily trading operations. In its simplest form, working capital refers to the current assets minus the current liabilities. The calculations vary from one business to another. Activities like a merger and acquisition (M&A) also have unique calculations. If you’re using virtual data rooms for your M&A, the working capital is among the calculations you must complete. Here’s an overview of the calculation:
Working Capital in General Transactions
In most mergers and acquisitions, the working capital is calculated by multiplying the target company’s earnings by a multiple. The earnings include taxes, interest, depreciation, and amortization, also known as EBITDA. M&A parties agree on the multiple, and buyers can include indemnification provisions and other holdbacks.
Buyers tend to require minimum working capital on the balance sheet when the deal closes. Having part of the working capital reduces the risk of immediate liquidity issues. The working capital is required for daily business operations and used when determining the company’s value. Here’s the simple calculation for working capital in mergers and acquisitions:
· Working Capital = Current Assets – Current Liabilities
If a company has $100,000 in current assets and $40,000 in current liabilities, the working capital would be $100,000 – $40,000, which is $60,000. Working capital can also be a ratio. The formula for the working capital ratio is current assets divided by current liabilities. With the previous example, the working capital ratio would be $100,000/$40,000, which is 2.5.
The figure represents how many times the company can pay its debts (2.5 times from the example above). If the working capital ratio is closer to 1, the company is more likely to experience financial difficulties. Such calculations are private and only disclosed in virtual data rooms and other private settings, like during M&A transactions.
Working Capital in M&A Transactions
Working capital is negotiable in mergers and acquisitions. Negotiations require the two parties (buyer and seller) to agree on working capital and the formula for calculating it. The deal determines how the working capital is calculated. If the parties negotiate on a cash-free, debt-free basis, then cash, notes payable, and lines of credit are excluded.
The purchase agreement defines the current assets and liabilities that affect the working capital. Assets and liabilities can include bank overdrafts, officers, employees, customer deposits, loss from owners, deferred revenues and taxes, and more. Here’s what you need to know about calculating working capital in an M&A transaction:
1. Average Working Capital
Working capital depends on current assets and liabilities, which change every day. M&A transactions take time to process, so the working capital can be significantly different when the deal is closed. Buyers tend to calculate the working capital by analyzing the numbers over twelve months. This calculation provides an average working capital for the year. Buyers can calculate the average over three months if the business grows rapidly.
2. Negative Working Capital
Businesses can have negative working capital when the current liabilities exceed the current assets. In such a situation, the monetizable assets cannot fully pay for the company’s debts. Negative working capital doesn’t mean the company is struggling financially. Working capital can be erratic and vulnerable to changes in payment habits.
3. Working Capital Target
Most parties in M&A transactions set a working capital target. The target specifies the amount the seller must have available when the deal closes. Setting a working capital target involves various factors, including what’s considered normal for the industry. You can calculate the capital as a percentage of sales and assess what causes the variation from normal levels. Find out if the capital needs growing and how seasonal sales and inventory affect the numbers.
Using Virtual Data Rooms for M&As
Mergers and acquisitions are private events only revealed after the deal is closed. Some of the paperwork involved is sensitive and must be restricted to specific partners. If you’re planning an M&A transaction, you need a secure platform to communicate with your team and partners. One effective solution is a virtual room.
Virtual data rooms offer a safe place to upload documents and share information with other stakeholders. The data room allows you to set access restrictions and determine who has the clearance to view specific information. Stick to reputable companies that offer dependable data rooms with intuitive tools for collaborations and M&A transactions.