What Is Working Capital?

At its core, working capital is the difference between a business’s current assets (such as cash, inventory, and receivables) and its current liabilities (such as payables and short-term debt). For the buyer, it represents the capital needed to ensure smooth operations from day one, covering obligations like supplier payments, order fulfillment and payroll. Thus, in a sale, even though it may be cash-free, debt-free, the buyer generally expects the business to have enough liquidity—receivables and inventory—to cover near-term obligations. If these assets fall short at closing, the buyer generally will expect the seller to leave cash to make up for it, unless the deal specifically contemplates that buyer will finance the short-fall.

The Importance of Normalized Working Capital

A key aspect of the transaction is setting a working capital target that reflects the business’s normalized working capital, which excludes any one-off or seasonal fluctuations. For example, temporary spikes in inventory due to seasonal orders or delayed receivables collection caused by unusual events should not influence the target. Normalized working capital reflects the ongoing level of capital needed for the business to operate efficiently.

This is where your financial advisor is essential. They will:

1. Analyze Historical Data: They will review the business’s financials over 12 to 24 months (or more) to calculate average levels of receivables, inventory, and payables.
2. Exclude Non-Recurring Items: Any one-off events, such as large infrequent orders or unusual payment delays, will be excluded to provide an accurate picture of the business’s normal working capital needs.
3. Set a Fair Target: Using this data, the advisor will help set a working capital target that reflects what is typically needed for the business to run smoothly.

Addressing Normalized Working Capital in the Preparation Stage and LOI

It’s important to address normalized working capital during the preparation stage of selling your business. Sellers should be prepared to propose a working capital target in the LOI, subject to the buyer’s financial due diligence. This helps avoid disputes later in the process. Without a specific working capital target in the LOI, sellers can find themselves negotiating a vague statement that only says the target will be agreed upon later based on “normalized working capital.” This often leads to misaligned expectations and unnecessary conflict during due diligence, which can delay or jeopardize the deal.

By setting a clear working capital target in the LOI, sellers establish a baseline that both parties can work from, while allowing for adjustments based on buyer diligence. This avoids unpleasant surprises and re-negotiations that might otherwise occur post-LOI.

Normalized Working Capital: Part Science, Part Art

The calculation of normalized working capital requires both a detailed examination of historical financial data and an element of professional judgment. Factors such as seasonal spikes in inventory or delays in receivables can be treated differently depending on the advisor’s perspective. Some anomalies may be excluded entirely, while others may be considered indicative of normal business operations.

This blend of science and art means that while both parties may rely on financial data, they may reasonably disagree on how to interpret it. This is why it’s important to approach the working capital target as a flexible figure—one that will be refined during due diligence based on input from both the buyer’s and the seller’s advisors.

Conclusion

Addressing normalized working capital early in the sales process, proposing a target in the LOI, and understanding the role of working capital adjustments at closing will help avoid costly disputes. Sellers should work closely with their financial advisors to arrive at a fair and defensible working capital target that balances both the science of financial analysis and the art of judgment. By doing so, they can protect their interests, promote a smoother transaction process, and set the stage for a successful deal.