Considering buying a business? Analysing the financial documents of a potential acquisition enables a buyer and their team to work out whether the business is profitable and stable. Amidst all of the reports and numbers, one calculation vital for buyers to make is working capital.
Read on to find out why…
What Is Working Capital?
Working capital is the cash investment needed to fund the running of a business on a day-to-day basis. For this reason, it is a key tool for informed decision-making.
As a business owner, managing your working capital helps to optimise cash flow and, generally speaking, the number grows along with the company.
It’s necessary for a business to have enough working capital in the bank to keep things ticking over and cover the next month’s costs should something unexpected happen – like a big client pays late or contests an invoice!
Working capital is the oil that lubricates the cogs of the machine that is your business and keeps it running smoothly. Benchmarking and tracking working capital can be a helpful tool for any business.
How To Calculate Working Capital Correctly
Most business owners calculate their working capital incorrectly. They take the cost of running for a year and divide it by 12.
But you see, your working capital will probably fluctuate month to month. Using a flat rate of “annual working capital divided by 12” leaves you in a precarious position where one month you may need more cash than you’ve anticipated.
That’s why I prefer to work out working capital a little differently.
Look at the last 12 months and identify in which calendar month the business had its largest cost implication. This is the figure you take as your working capital.
Why? Because when you work it out like this, you’ll know that you’ll always have the working capital you need – even in your more cash-intensive months.
As time goes on, if the business has an even larger level of cost running through it during a calendar month then this is what you should adopt as your new working capital requirement.
How Does Working Capital Impact Sale Proceeds?
For small business transactions, the issue of working capital is usually straightforward. The seller often retains the accounts receivable (money being paid in) and pays off accounts payables (all liabilities) in a fairly short time frame.
Of course, it’s not always that simple. Deal structures vary across the board. And, most importantly, buyers need an accurate working capital calculation to determine how to fund their first few weeks and months of acquiring this new business.
And if your buyer doesn’t feel the need to calculate working capital, you can be sure their lender does!
So as the seller, managing and understanding your accurate working capital figure is vital to a healthy, straightforward sale.
Why?
As a seller, you want your business sale to go smoothly. Poorly managed working capital can be one of the sticking points in the sales process.
If adequate working capital is not covered in the sales and purchase agreement then the buyer cannot deduct it from the agreed purchase price. But if it is covered and the company is short, then the buyer can insist on deducting the working capital requirement before releasing any relevant balance to you.
And from the buyer’s point of view?
If they suddenly need to come up with a surprise amount of funding at the last minute that wasn’t noted in the purchase agreement, are they going to be happy?
Surplus Working Capital
The situation might run the other way, of course.
If a business owner manages their working capital well and finds themselves with a surplus, they may choose to leave the funds within the business whilst still in operation. Or they may prefer to take it out in a tax-efficient manner, like a dividend.
That said, it usually makes sense to leave the excess cash in a business and have it paid out at the point of sale, as the seller will get Entrepreneurs Relief up to £1m and pay just 10% tax.
Managing Your Working Capital Can Increase Your Sale Price
Both buyers and sellers need to have a real understanding of how cash flows through the business up for sale.
Not only does sound analysis of the financial documents solidify the stance of the buyer and allow them to make fair valuations, but it also decreases the chance of unexpected disputes upon closing the deal.
Clarity and simplicity are vital here. A seller should have well-defined descriptions how working capital has been calculated, and how they anticipate it to be calculated in future, prepared and available for any prospective buyers to view at any stage of the sales process.
In the UK, a buyer is responsible for drafting Head of Terms (HOTs) and in the US a Letter of Intent (LOI). If they fail to make provision for working capital in this pre-contract agreement or the SPA then they will suffer the consequences.
Do You Track And Manage Working Capital?
Is this part of the sale process giving you a headache?
Not everyone has financial training, but The Business Success Consultant does. Book a call with Clive today for help creating a stress-free sale.
