Modelling Working Capital - Best Practices

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December 16, 2020

by a searcher from The University of North Carolina at Chapel Hill - Kenan-Flagler Business School in Toronto, ON, Canada

Beyond the normally accepted WC Peg of average working capital for the last 12 months, what are some best practices/modelling techniques to arrive at the ideal level of WC for a transaction, knowing that you don't know the target company's operations that well compared to the seller?

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commentor profile
Reply by an intermediary
from The University of Chicago in Chicago, IL, USA
1. The concept of Debt-Free Cash-Free *DFCF) balance sheet is too childish. It gets many deals in trouble.
2. M&A NWC is different than accounting NWC.
3. What should be included in M&A NWC? Many good points by others. But, one should not include items like A/R and A/P just based on label. Often certain trade A/R or trade A/P need to be excluded.
4. What should one do with prepaid deposits, deferred revenue? Starting point is that they are debt-type liabilities and hence excluded. Some can be included subject for deeper drive.
5. Should buyer assume all accrued expenses and accrued wages? This is a complex subject. Often can be ignored of amount is not material. Accounting practice for COGS impacts this analysis.
6. Changes in accounting policy can impact NWC. They should be analyzed. Things get tricky whether they are on the left-side or right-side of BS.
7. NWC for businesses in healthcare, construction (w/% completion method), long production cycle get even more challenging. Recently a $40 M purchase price healthcare deal had collapsed after 12 months on WC issue. They contacted me and we brought both sides to reality. Buyer was represented by PwC.
8. I teach this subject. I share my unpublished book with the class (wrote it 10+ years ago). I introduce benefit theory and the debt-type liabilities to resolve buyer/seller conflict on the subject. Hope one of these days I can publish the book. . (I believe Deloitte has changed debt-type to debt-like)
commentor profile
Reply by an intermediary
from Wake Forest University in Winston-Salem, NC, USA
The article ^redacted‌ mentions highlights a critical point - 80% of the categories that should be considered are obvious; it is the obscure ones that might be more tricky. Get the internal, full-blown balance sheet (not just the consolidated BS from the published financial statements or tax returns) and make sure you understand what each line does, how and when it is entered/adjusted in the accounting process, and how it has trended over the last 24-months. When it is written up in painful detail (I recommend listing each chart of accounts # that is included), double-check it. We had a document written up by the attorney that reversed one of the accounts, which would have cost the seller about $150k had we not caught it.

p.s. - as an aside, and see other posts on the subject, the "normally accepted NWC peg" depends greatly on the size of the transaction, the industry, the data set used for comps, and thus the basis of the price (base, base+inventory, base+inventory+AR-AP, etc.).
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