One of the ways to determine whether an acquisition target makes for a good fit as an M&A target is to calculate the company’s working capital. Acquirers need to assess as many signals as possible to ensure that the target company is as healthy as it claims to be and that it maintains optimal operational efficiency.
One of the ways to measure financial soundness is to calculate the company’s working capital.
What is Working Capital, and How Do You Calculate It?
Working capital is a measure of a company’s short-term financial health and its ability to meet its financial obligations. It is an important assessment of the financial health of a company, as the metric helps determine its ability to operate and grow in the short term. When assessing the potential targets for an M&A transaction, the working capital of a target company is important for the acquiring company to measure.
Working Capital Formula
The formula is rather simple:
Working Capital = Current Assets – Current Liabilities
Here are the steps to calculate working capital:
- Determine the current assets: This includes assets that are expected to be converted into cash within one year, such as cash, accounts receivable, inventory, and short-term investments.
- Calculate the current liabilities: This includes liabilities due within one year, such as accounts payable, short-term loans, and current portion of long-term debt.
- Subtract the current liabilities from the current assets: The resulting figure is the working capital
Some common examples of current assets that a company would use to calculate a target company’s working capital include
- Cash and cash equivalents. This includes cash on hand, bank deposits, and highly liquid investments that can be easily converted into cash.
- Accounts receivable. This represents the money owed to the target company by its customers for goods or services sold on credit.
- Inventory. This includes raw materials, work-in-progress, and finished goods that the target company has in stock and intends to sell.
- Prepaid expenses. This refers to expenses that the target company has already paid for but have not yet been used up, such as insurance premiums or rent.
- Short-term investments. These are investments that the target company intends to hold for less than one year, such as marketable securities.
- Other current assets. This includes any other assets that the target company expects to convert into cash within the next year, such as tax refunds or advances to suppliers.
Current liabilities that a company would use to calculate a target company’s working capital might include
- Accounts payable. This represents the money that the target company owes to its suppliers for goods or services received on credit.
- Accrued expenses. This refers to expenses that the target company has incurred but has not yet paid, such as wages and salaries, interest, and taxes.
- Short-term debt. These are loans that the target company has taken out with a maturity of less than one year.
- Current portion of long-term debt. This represents the portion of long-term debt that is due within the next year.
- Unearned revenue. This refers to the money that the target company has received in advance from customers for goods or services that have not yet been delivered.
- Other current liabilities. This includes any other liabilities that the target company expects to settle within the next year, such as customer deposits or dividends payable.
It’s worth noting that the specific assets and liabilities that are included in the calculation of current assets may vary depending on several factors, such as the accounting practices and standards used by the company performing the analysis. These might also be related to how the particular industry in which the company operates accounts for certain assets. For example, a SaaS software company might account for revenue differently than would a manufacturing firm.
Advantages of Calculating Working Capital
Because working capital is used to fund operations and meet short-term obligations, measuring it provides insights into the day-to-day operations of a target company. A positive working capital indicates that a company has sufficient funds on hand to meet its short-term financial obligations. On the other hand, a negative working capital indicates that a company may struggle to pay off its current liabilities and may face liquidity issues.
When assessing potential targets for an M&A transaction, it’s important to consider the working capital of the target company as it can affect the financial stability and growth potential of the combined entity.
A target company wishing to enter into an agreement with an acquiring company or take investments from financial buyers would want to present itself in the strongest possible light, including demonstrating positive working capital.
With enough working capital, the company does not face any liquidity crunches and can meet payroll, debt obligations, accounts payable, and even tax liabilities. Companies with strong, positive working capital also put themselves in an easier position should they need to apply for loans or other types of credit, as a way to fund business growth. This is important during an M&A transaction, as the acquiring company might need to access multiple financial instruments or asset classes to fund the deal — including short-term debt. If the target has strong working capital, the deal will become more attractive for banks and other financing providers.
Working capital can also address fluctuations in revenue, which is helpful for acquiring companies or investors unaccustomed to the variations in capital inflows of companies in an industry in which the target company operates. Working capital provides a more accurate picture of the target company’s finances a year out rather than simply focusing on its current balance sheet. This is helpful for businesses that experience seasonality, such as retailers or hospitality providers.
Why Companies Need a Virtual Data Room to Assess Working Capital and Accelerate Transactions
Assembling all of the documents and data necessary to calculate working capital and perform other aspects of financial due diligence can become complex. Proof of assets and liabilities can be stored in various documents, and acquiring companies and their bankers need access in order to calculate the working capital of the target company, as part of an M&A transaction.
A virtual data room (VDR) is the solution to host important documents in the cloud in order to assure speedy due diligence while maintaining the highest levels of privacy and security. With rights management, permissioning, tracking, and other advanced features, understanding a target company’s short-term financial health could become a challenge, and could delay a transaction should the acquiring company be interested.
Organizations should consider an enterprise document security solution like Caplinked, which has years of experience working with corporate, financial, and legal teams and providing VDRs for transactions of all sizes.
Jake Wengroff writes about technology and financial services. A former technology reporter for CBS Radio, Jake covers such topics as security, mobility, e-commerce, and IoT.
Sources
Investopedia – How Do You Calculate Working Capital?
Oracle – What is Working Capital? How to Calculate and Why It’s Important
