If you’re considering selling or buying a business, something you need to pay attention to is working capital. As a seller, you want to maximize the working capital you have on your balance sheet to make your business appealing. As a buyer, you want to make sure you understand how much of the working capital that’s listed on the balance sheet will be yours once the sale goes through.
To that end, understanding working capital adjustment may come in handy. Keep reading to learn more on working capital adjustment, when they occur, the working capital adjustment formula, and more.
Key Points
• Working capital adjustment involves recalculating the working capital at a specific point in time, often during mergers, acquisitions, or financial analyses, to ensure fair valuation and proper financial planning.
• In business deals, working capital adjustments ensure that buyers and sellers account for any deviations from a predetermined target working capital, reflecting the company’s real-time operational needs.
• Adjustments typically involve changes in current assets (like accounts receivable and inventory) and current liabilities (such as accounts payable and accrued expenses).
• Proper working capital adjustments can prevent disputes, protect the financial interests of both parties, and ensure smooth transitions during acquisitions or partnerships.
• Businesses can prepare for adjustments by maintaining accurate financial records, forecasting seasonal variations, and understanding industry benchmarks to set appropriate target working capital levels.
What Is Working Capital Adjustment?
Working capital adjustment is used to reconcile the working capital levels of a business at a specific point in time, often during transactions like mergers or acquisitions. It ensures that the actual working capital at closing aligns with the target working capital agreed upon by both parties.
Working capital, the difference between current assets and current liabilities, is essential for daily operations, and any significant deviation from the expected level can impact a business’s liquidity and functionality. Working capital adjustments account for these variations, ensuring fairness and accuracy in the financial valuation of the business being bought or sold.
Recommended: Change in Net Working Capital, Explained
When Do Working Capital Adjustments Occur?
A working capital adjustment needs to be a part of the negotiation conversation from the start. Both the buyer and seller need to be clear on which, if any, assets on the balance sheet will be transferred to the new owner. Because working capital factors into the valuation of the company, removing some or part of it from the equation likely will create a change in the valuation if that number is significant.
If the seller plans to take a large amount of the working capital to cover expenses, the buyer may need to explore different types of business loans to fund the working capital budget to ensure there’s enough money for the business to operate. Another important discussion between the buyer and seller is on how much it costs to operate the business over a given period of time. This way, the buyer has an understanding of how much working capital should be negotiated to keep.
If working capital fluctuates drastically, the actual adjustment may not happen until closing. However, the buyer and seller need to agree on how the adjustment will occur early on. This could be a dollar-for-dollar adjustment that reduces the selling price by the amount of working capital that the seller retains or spends. It could be a de minimus or capped adjustment, where adjustments are only made up to a specified level. Whatever the adjustment strategy, this needs to be agreed upon early.
Recommended: Business Cash Management, Explained
Working Capital Adjustment Formula
While the formula for working capital itself is simply current assets minus liabilities, to calculate the working capital adjustment, the buyer and seller need to agree on a working capital target. Let’s dive deeper.
Working Capital Targets
Working capital targets are an estimate of the amount of working capital that will be available at closing on the sale of the business. This amount should be sufficient to operate the business for a specified period of time.
Any amount over or under this target will need to be paid either to the buyer or the seller, accordingly.
Working Capital Adjustment Example
Let’s say the balance sheet on January 1 — when the business goes up for sale — shows working capital of $500,000. This is appealing to an investor. But on February 15, the company used $400,000 of that to pay debts. The seller might believe she’s acquiring a company with half a million in working capital, when that’s not true.
By including a working capital adjustment in the negotiation of the sale of the business, the buyer can be protected from a loss like this. The buyer can insist that the valuation be reduced, based on the fact that $400,000 is now gone from the company.
Likewise, if the company suddenly comes into an extra $300,000 between the listing of the business and the purchase, that might increase the initial valuation and thus the selling price. If the price were to increase at the last minute, the buyer might have to take out an additional business working capital loan to purchase the company, or the agreement might be for the seller to take the extra working capital.
Having a working capital adjustment eliminates unexpected surprises like these and instills trust between the buyer and seller.
Recommended: How to Read Financial Statements: The Basics
Pros and Cons of Working Capital Adjustment
Understanding how working capital adjustment affects the sale of a business is important, as is looking at both the benefits and drawbacks.
thumb_up
Pros:
• Ensures seller isn’t taken advantage of by a loss of working capital
• Keeps buyer and seller on the same page
• Seller has enough money to operate company after transfer
thumb_down
Cons:
• Seller may get less working capital from the sale
• Business value can go down
• Negotiations may slow down sale process
💡 Recommended: Small Business Tax Tips
Pros
It’s in a seller’s interest to have the highest possible value for a company that’s for sale, but without a working capital adjustment, the buyer could pay more than the actual value of the business after working capital is removed. The adjustment remedies this issue.
It also fosters healthy communication during the negotiation process, as well as provides transparency. And with the working capital adjustment, the seller is assured to have enough capital to run the business without having to take out a loan.
Cons
The seller may have visions of taking out a chunk of working capital to cover debts or pay himself once the deal goes through, but a working capital adjustment prevents this from happening. If a sizable amount of working capital is removed from the balance sheet, the business valuation may go down, and therefore the business may be sold for less than the asking price.
Finally, agreeing on a working capital adjustment may take time in the negotiation process, which may slow down the sale.
Recommended: 6 Step Guide to Getting a Small Business Loan
The Takeaway
Including a working capital adjustment in the negotiation of the sale of a business protects the seller from overpaying for the company and creates clear communication between the buyer and seller. Start the conversation about working capital adjustment early, and be willing to negotiate to find a happy medium for both the buyer and seller.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is the point of working capital adjustments?
The point of working capital adjustments is to ensure fairness in business transactions by reconciling the actual working capital at closing with the target amount agreed upon by both parties.
Is working capital added to the purchase price?
Working capital is typically factored into the purchase price through a target working capital amount agreed upon during negotiations. Any deviations from this target at closing may result in a working capital adjustment, either increasing or decreasing the final purchase price to ensure fairness.
Does negative working capital adjustment exist?
Yes, negative working capital adjustment exists and occurs when the actual working capital at closing is lower than the agreed-upon target working capital. In this case, the purchase price is reduced to account for the shortfall, ensuring the buyer does not overpay for the business.
Photo credit: iStock/Delmaine Donson
SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.
This content is provided for informational and educational purposes only and should not be construed as financial advice.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
SOSMB-Q424-066