The definition of working capital (W/C) is rather simple: current assets less current liabilities. The ratio is current assets/current liabilities. Any ratio below 1 is negative. For most companies a ratio of 1.2 to 2.0 is sufficient.
The above description is pretty basic. Positive W/C is required to ensure an entity continues its operations and has funds sufficient to satisfy short-term debt and upcoming operating expenses. The management of W/C involves controlling inventories, accounts receivable (A/R) and payable (A/P), and cash. Working capital needed for the going enterprise is a critical component of selling a business. Thus, the calculations should be carefully considered, with these factors in mind:
- W/C Cycle – the time required to turn net current assets into cash. The cycle also includes how fast to pay liabilities, as well as the analysis and collection of good receivables. The shorter the A/R cycle, the faster is the recovery of cash.
- Cash Conversion Cycle – the net number of days from the cash outlay for raw material to the receipt of the customer payment. The obvious aim is a low net number of days. It also can determine available cash to meet daily expenses.
- Inventory Management – uninterrupted production occurs with the proper balancing of raw materials, work-in-process, and finished goods. The keys here are an effective supply chain and Just in Time (JIT) delivery of raw materials.
As part of a company sale, the buyer is concerned with the working capital management, especially the cash conversion cycle. One way to ascertain the real W/C needs of a seller is to analyze each month for the last 12-24 month period. This extended period should smooth any seasonality and provide a clearer picture of W/C/. On the other hand, the seller wants an accurate reflection of working capital to isolate the excess cash on hand, that should not be considered part of the normal W/C cycle. This excess cash is added to the transaction value to arrive at the aggregate purchase price.