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There’s often considerable confusion around how working capital is treated when selling a business. Owners and even some advisors may not fully appreciate how capital affects valuation, sale price allocation, and post‐sale adjustments. Overlooking its importance can lead to unintentionally surrendering value—sometimes hundreds of thousands of dollars—without realising it.
Working capital refers to the pool of current assets and liabilities that are essential for a company’s day‐to‐day operations. These items continuously cycle through different forms—inventory becomes receivables, receivables become cash, and cash is used to settle payables, and so on. On the asset side, working capital comprises inventory, trade debtors and prepayments.
On the liability side, it includes trade creditors, accruals, employee entitlements, GST liabilities, and customer deposits. Each of these line items fluctuates as business activity ramps up or winds down. Because they are so dynamic and integral to operations, capital must be carefully analysed—and ultimately agreed upon—when the business changes hands.
When it comes to valuing a business, working capital is inseparable from enterprise value. No credible valuation can ignore the cash cycle or omit the day‐to‐day net funds required to generate profit. After all, it is the movement of cash through working capital accounts that allows the business to keep trading. A valuation that excludes working capital is akin to valuing a store on its storefront without considering the stock on its shelves. Whether the buyer and seller negotiate a multiple of earnings, a discounted cash‐flow model or an asset‐based approach, capital underpins the cash flows and profitability being measured.
Is More or Less Working Capital Better?
Whether having more or less working capital is advantageous depends heavily on context. In a going‐concern scenario (i.e., “run the business” mode), many companies aim to keep net working capital at a minimum. By reducing the amount of capital tied up in receivables, inventory and other current assets, a business can free up cash for growth initiatives, pay down debt or invest in capital expenditure. Businesses that maintain lean working capital cycles often achieve higher returns on funds employed. Efficient receivables collection, accurate stock forecasting and negotiating favourable payment terms with suppliers are tactics used to drive working capital optimisation.
Yet, it’s surprisingly common for working capital to creep upwards without the owner realising it. As sales and margins grow, inventory levels must rise to meet demand. To secure volume discounts, management might buy in bulk and hold more stock than necessary. Offering customers generous payment terms—such as 60 or 90 days—boosts sales, but at the cost of skyrocketing trade debtors. Likewise, paying suppliers promptly or even early can improve negotiation leverage, but increases the cash outflow before inventory is turned into revenue. All these well‐intentioned decisions can inflate capital beyond an optimal level. The more funds trapped in current assets or used to settle current liabilities, the less available cash remains for strategic opportunities.
Once a business owner switches from “run mode” to “sell mode,” the dynamics around working capital change dramatically. Targets and buyers look at how much net capital must remain in the business upon completion—essentially, how much cash is needed to keep it trading seamlessly for the next few weeks or months. Too little capital left in the business could force the buyer to top up cash immediately, whereas too much working capital left behind effectively dilutes the purchase price. Sellers soon realise that trimming capital before sale—not by jeopardising operations but by tightening inventory levels, accelerating debtor collection and aligning payables—can free up cash that contributes directly to proceeds at completion.
Why Working Capital Influences Goodwill and Purchase Price
Although capital is a balance‐sheet concept, it directly affects goodwill and overall purchase price. Goodwill represents the intangible value—brand equity, customer relationships, proprietary processes—that cannot be separately identified on the balance sheet. When a buyer appraises a company, they look at earnings before interest, tax, depreciation and amortisation (EBITDA) or some other profit metric, then apply a multiple to arrive at an enterprise value.
From that enterprise value, they subtract net debt and adjust for a normalised level of net working capital to arrive at equity value. If the business is loaded with excess capital at closing, the buyer effectively overpays for assets that are simply cycling through the business, not creating lasting value. Conversely, if working capital is below what’s needed to run the business smoothly, they will deduct the shortfall from the purchase price, so the seller loses value.
Consequently, any misalignment or misunderstanding about “normalised” capital levels can trigger disputes at completion. For instance, if the seller’s balance sheet shows $500,000 in inventory and $300,000 in receivables, but the buyer believes a normal operating level is $700,000, the buyer will insist on clawing back the $200,000 difference. This “working capital adjustment” often leads to frantic last‐minute negotiations, legal fees and delays in settlement. Many owners—unaware of how fluid capital can be—find themselves on the back foot, unexpectedly walking away with less than they thought.
How to Calculate Normalised Working Capital
Calculating normalised capital involves reviewing historical months (often 12 to 18 months) and determining the average levels of receivables, inventory, payables and other current items. Seasonal businesses, for instance, might exhibit spikes and troughs in inventory ahead of peak periods; this volatility must be smoothed out to arrive at a representative average. Once the average gross receivables and inventory are determined, subtract average payables and accrued liabilities to derive net capital. This normalised figure becomes the reference point for the purchase agreement.
During negotiation, the seller will propose a “working capital peg”—a target amount of net capital that must remain in the business at close. If actual capital at the completion date is higher than the peg, the seller typically retains the surplus as additional cash proceeds. If it is lower, the buyer deducts the shortfall from the final price. Because of this, proactive sellers often undertake a “working capital clean‐up” in the months leading up to a sale: they freeze unnecessary stock purchases, expedite receivables collections and prepare accrual schedules. A clean balance sheet, aligned with the historical average, reduces the likelihood of large post‐completion adjustments.
Common Pitfalls to Avoid
A frequent error is failing to involve accountants early enough in the sale preparation. Business owners might focus exclusively on EBITDA improvement—cutting expenses or boosting sales—while overlooking working capital management. Consider a company that drives sales by extending credit terms to customers but doesn’t adjust its inventory planning or payables scheduling. Its profit margins look strong on paper, but the cash is locked up in trade debtors. Should a buyer demand a normal capital level based on 90 days’ turnover, the seller might struggle to hit the target if receivables collection has slowed.
Another pitfall is misclassifying certain line items. For example, “current portion of long-term debt” or “income tax payable” are sometimes lumped into capital, yet they may not truly reflect operational capital needs. Clarity around which items are operational (inventory, receivables, payables) versus financing or non-operational items ensures a fair capital calculation. Buyers typically scrutinise every line, so any lack of transparency will be penalised through a lower valuation or a larger adjustment at completion.
Best Practices for Sellers
Begin planning for capital adjustments at least 6 to 12 months before you intend to sell. Engage your accountants to run monthly reviews of receivables days outstanding (DSO), inventory turnover ratios and payables days. Identify slow‐moving stock items and develop strategies to liquidate or write them down. Implement consistent credit and collection policies so that receivables ageing remains within acceptable ranges. At the same time, negotiate favourable payment terms with suppliers—perhaps moving from 30 to 45 days—so that payables stretch without straining relationships.
Communication with buyers is also crucial. Be transparent about how you calculate normalised capital, share historical trends and be prepared to justify any outlier months. A well‐documented capital analysis fosters trust and accelerates due diligence. Where possible, include a “true‐up clause” in the sale agreement that outlines the mechanism for determining actual capital at closing, the timeline for post‐closing adjustments and dispute resolution methods. Clear contractual language can prevent drawn‐out negotiations that erode goodwill and rack up legal fees.
Why Working Capital Matters More in Some Industries
Certain industries—retail, manufacturing, wholesale distribution—are more working‐capital‐intensive than others. A manufacturer may need substantial raw‐material inventory on hand and prepay suppliers to secure volume discounts, driving up working capital needs. In contrast, a software‐as‐a‐service (SaaS) business might have minimal inventory but significant deferred revenue and employee entitlements on the liability side. Understanding these industry nuances is critical when negotiating a sale. A buyer familiar with your sector will recognise what constitutes a reasonable working capital level, whereas one unfamiliar might interpret high stock levels as inefficiency rather than necessity.
In service‐oriented businesses—consulting firms, agencies, professional practices—working capital may appear relatively low, but deferred revenue, unbilled work in progress (WIP) and employee leave provisions still count. Failing to account properly for unbilled WIP can result in an artificially low working capital peg, leading to a rude surprise when the buyer demands back the shortfall. Similarly, rolling over annual leave balances or long service leave liabilities without factoring them into net working capital can inflate the seller’s final proceeds prematurely.
Conclusion
Whether you’re a seasoned entrepreneur or a first‐time seller, understanding how working capital influences valuation, sale price and post‐deal adjustments is non‐negotiable. From initial preparation—streamlining receivables, optimising inventory, negotiating payables—to negotiating a clear working capital peg in the sale contract, each step demands attention. Failing to do so risks leaving cash on the table or, worse, scuttling a deal at the last minute.
Ultimately, working capital is more than a line in the balance sheet; it is a barometer of operational health and a pivotal element in commercial negotiations. By taking a proactive, well‐informed approach to managing and calculating working capital, sellers can maximise their chances of a smooth transaction, preserve value, and achieve the successful exit they have worked so hard to deserve.
Always speak to expert before making any decisions.
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