Cash Accounting Working Capital

July 09, 2024

by a searcher from George Mason University - School of Business in McLean, VA, USA

For a Main Street business around 1.5M in rev, and using cash accounting, does anyone know a good way to estimate working capital requirements? For my LOI, I indicated 'Work in Progress" not yet invoiced and inventory as my working capital, because accounts receivable does not exist, and accounts payable is paid up monthly. Let me know your thoughts on this matter.

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Reply by a searcher
from Johns Hopkins University in Atlanta, GA, USA

^redacted‌ take your DSI (Days Sales in Inventory), add your DSO (Days Sales Outstanding), and subtract your DPO (Days Payables Outstanding): DSI + DSO - DPO. That will give your cash conversion cycle. You can put your payroll into your DPO, or keep it outside. Regardless, your cash conversion cycle tells you roughly how much cash you have tied up as a proportion of revenue (assuming no seasonality, etc.). So, for instance, if my revenue is $1.5M/year and my cash conversion cycle is 30 days, then (assuming a 10% profit margin), I've probably got somewhere in the neighborhood of $1.5M/###-###-#### ($1.5m/12) = $###-###-#### tied up in working capital. A prudent reserve would be 3x-6x this amount in cash and cash-like ability, but you're unlikely to get that in the initial phases of a purchase (here, consider a LOC in the $225k range). Hope this helps...and <fair warning> I did this off the cuff, so please check my work. The concepts are solid, I may have missed something in here...now, back to work.

Reply by an intermediary
from Babson College in Boston, MA, USA

Easiest approach is to suggest the seller leave x months of operating costs (biggest being payroll, rent) in cash for business. 2-3 would be ideal (excluding materials/inventory). Then treat any unpaid payables due as debt and they remain the sellers responsibility. It’s impossible to do an adjustment post close on a business that doesn’t track NWC. There’s another concept of your watch my watch, where if it occurs prior to close they get it (AR/AP) after it’s your responsibility. If it’s inventory based business you benefit from what’s on hand.

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