Oct 08, 2023
When it comes to mergers and acquisitions (M&As), working capital adjustment is an essential part of the process that many tend to overlook. It refers to the calculation of the net working capital of a business, which includes current assets, liabilities, and cash flow. Understanding this adjustment can unlock cash flow for your business and provide insights into its financial health.
In this blog, we will explain:
- What working capital adjustment is
- How to calculate it using different formulas
- The implications in M&A deals
We also talk about factors affecting net working capital and strategies to minimize disputes during the adjustment process. By the end of this blog, you will have a clear understanding of key takeaways for working capital adjustments in B2B deals.
What is working capital adjustment?
Working capital adjustment is a clause in sales agreements that guarantees payment to the seller for the company's assets and liabilities up to the closing date.
This adjustment accounts for changes in working capital items like inventory, accounts receivable, and accounts payable. Accurately negotiating and calculating these adjustments can prevent disputes between parties.
Calculating working capital adjustment
To ensure fair purchase price in M&A deals, understanding the working capital adjustment formula is crucial. It calculates changes in current assets and liabilities from cash and cash equivalents to debt. A positive result makes buyers pay more and vice versa.
The agreement's clauses account for accounts receivable/payable and inventory. Careful negotiation helps avoid disputes after closing date. This method avoids starting with "working capital adjustment," making it easier for target companies during due diligence process or even private companies during financing or mergers. Auditors use Generally Accepted Accounting Principles (GAAP) to calculate balance sheets efficiently.
Learn more: What is working capital and how to calculate it?
Understanding GAAP and dollar-for-dollar adjustments
Proper comprehension of GAAP is vital when it comes to M&A as it is the standard for financial reporting in the United States. In order to ensure a fair purchase price of a business during M&A transactions, dollar-for-dollar adjustments are made based on its working capital at closing.
These adjustments account for various points such as inventory, accounts receivable, and accounts payable so that there will not be any disputes between buyer and seller regarding purchase price adjustment.
Implications of working capital adjustment in M&A deals
Proper due diligence is crucial to identify potential risks associated with working capital adjustments that have implications in M&A deals. Negotiating favorable terms benefits both parties. Seeking guidance from experienced professionals like lawyers and accountants helps navigate complex issues. The seller's estimate of the working capital amount should be justified during negotiations. Litigation may occur if there is a shortfall at closing relative to the target working capital or net working capital threshold specified in the purchase agreement.
It is important to understand GAAP and dollar-for-dollar adjustments when making purchase price calculations based on levels of working capital in the short-term and long-term.
Factors affecting net working capital in M&A deals
During an M&A transaction, it's essential to evaluate the factors that affect the net working capital of the target company. This includes scrutinizing the current assets and liabilities including accounts receivable and inventory trends.
Additionally, industry-specific considerations such as seasonal fluctuations or supplier relationships should also be taken into account during due diligence. Accurately determining the amount of working capital needed can help avoid disputes between buyer and seller at closing. Seeking guidance from lawyers or auditors can also ensure compliance with GAAP accounting principles while calculating purchase price adjustments based on closing balance sheets.
Strategies to minimize disputes during working capital adjustment
To reduce disputes related to working capital adjustment, it is essential to have a clear definition of terms and agree on a calculation methodology in the purchase agreement. Resolving any discrepancies before closing can help avoid litigation. It is also advisable to anticipate potential conflicts and address them through alternative dispute resolution mechanisms such as mediation or arbitration. Doing so ensures that the closing process is smooth and without issues, allowing both parties to move forward with their plans.
Key takeaways for working capital adjustment in B2B deals
In M&A transactions, it is vital to address working capital adjustment accurately to determine the correct purchase price on the closing date based on the company's working capital amount. This amount can be calculated using either a target working capital or a closing balance sheet mechanism, which must be defined in detail in the purchase agreement. Besides, financial advisors or accountants can assist in estimating the required amount of working capital for a smooth transaction process.
Due diligence is necessary to assess various points such as current assets and liabilities, accounts receivable, net working capital, etc. Ensure enough working capital is available at closing and avoid negative or shortfall situations which might lead to litigation.
Boost cash flow
In conclusion, working capital adjustment is an essential part of M&A deals and B2B transactions. It helps companies to assess the liquidity of the business by measuring the difference between current assets and current liabilities. A thorough understanding of GAAP and dollar-for-dollar adjustments, as well as factors affecting net working capital, is crucial for successful negotiations.
Strategies such as setting clear definitions and thresholds can help minimize disputes during working capital adjustments. At the end of the day, a well-executed working capital adjustment can unlock cash flow that can be reinvested in the business. Resolve Pay will unlock your cash flow and transform the financial health of your business. Find out how.
