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Working capital is a snapshot of a moment in time that measures the level of assets a business has available to meet its short-term obligations. It is not found on the balance sheet as a line item but is calculated easily with several figures which do appear on the balance sheet. Defined simply, working capital is the difference between current assets (cash, inventory, accounts receivable, etc.) and current liabilities (accounts payable, current portion of long term loans, accrued expenses, etc.)
Conversely, the “change in working capital” describes what is happening over a given period of time concerning the liquidity of a business. A change in working capital is important to monitor and is often used when analyzing and valuing a business.
What is change in working capital?
From an accounting standpoint, change in working capital refers generally to the difference in working capital from the previous year to the current year, and is an important indicator of a company’s financial performance and liquidity over time. Calculating the change in working capital creates an understanding of a company’s capital cycle – and how efficiently it can reduce the cycle by collecting receivables and/or delaying accounts payable.
To determine the “change in working capital”, it is necessary to evaluate whether current operating assets and current operating liabilities are increasing or decreasing.
When does a change in working capital matter if you are selling or buying a business?
Whether a business is acquired via a stock purchase or asset purchase, the buyer will likely prepare an offer based in part on an assumption that they will have a certain level of liquidity on the balance sheet when the business transfers. This assumption generally comes from the buyer’s review of the balance sheet (and the other financial statements) provided during the selling process. In most cases the working capital of a given business for sale is substantial and is incorporated its valuation.
Because the business value and offer made is based in part on its working capital (liquidity), most buyers will insist on including a working capital target for the closing date. When this is done, the buyer will impose a closing day purchase price adjustment for the excess or shortfall in the business’s working capital target as defined in their Letter of Intent and/or purchase agreement.
Both the buyer and the seller of a business should be aware of a working capital target when negotiating the business acquisition as it may have a large impact on the amount of cash changing hands at closing.
What does change in working capital mean for small and medium business owners?
Monitoring and understanding these changes over time can help small and medium sized business owners understand their cash flow. Specifically, analyzing changes in working capital is critical for companies who experience seasonal or erratic cash flow. A negative change in working capital for an extended time may be an indication of financial problems, while a long term positive change in working capital could be an indicator of financial stability.
Business bankers keep careful watch over their customer’s working capital and change in working capital from year-to-year. So, for that reason alone it’s always a great idea to know and monitor the working capital for your business.