M&A Glossary
Net working capital: formula and how to calculate it
Net working capital is current assets less current liabilities. It shows how much a company has to keep tied up in inventory and receivables simply to operate. In a transaction it is one of two items, alongside debt, that bridge enterprise value and the amount actually paid to the seller.
Formula and how it is measured
Net working capital = current assets less current liabilities. The transaction definition is narrower: inventory plus trade receivables less trade payables. Cash and borrowings drop out, because they are handled separately as net debt.
A positive figure means the company funds its own trading cycle. A negative figure, common in retail, means suppliers fund it.
The target level, and where disputes come from
The parties agree a target level in the agreement, usually an average of the last twelve months. If working capital at closing is above target, the seller receives a top-up. If below, the price falls by the difference.
The mechanism is simple. The dispute comes from elsewhere: how to average a seasonal business and which items belong in the calculation. An ice cream maker in July and in January is two different companies on the balance sheet. That is why the target is negotiated on monthly data for a full year, not on the year-end balance sheet.
What to do before a sale
Artificially depressing working capital before closing, by holding back supplier payments or running down inventory, shows up immediately in monthly data and ends in an adjustment the other way plus a loss of credibility. What does work is genuine improvement in inventory turns and shorter customer payment terms, run over a year or two before the process. That lowers the target level permanently, and the benefit stays with the seller.
Frequently asked
Questions about working capital.
What is the formula for net working capital?
Current assets less current liabilities. In the transaction version: inventory plus trade receivables less trade payables, excluding cash and borrowings.
Is negative working capital a problem?
Not always. In retail and parts of services it is normal and means suppliers finance the trading cycle. It becomes a problem when it results from late payments rather than from the business model.
How should a change in working capital be read?
Rising working capital on flat sales means cash is freezing in inventory or receivables. Falling working capital on rising sales is usually a good sign, provided it does not come from stretching supplier payments.
See also
- Working capital in a transaction: the most common price dispute - how the parameter plays out in negotiation
- M&A glossary - 72 terms used in transactions
- How we run a company sale
- How we work and how we charge