When selling a business, working capital is typically part of what the purchaser is acquiring and plays a big role in the valuation of the company. It is also one of the most frequently negotiated aspects of a deal. Buyers and sellers often reach different conclusions about how much working capital the business needs to run, and the concept itself is not always well understood. In practice, working capital will generally fall into one of three outcomes.

• The business has an appropriate level to support ongoing operations
• The business holds more working capital than it reasonably needs
• The business does not have enough working capital to operate as intended

The central issue is determining how much working capital the business needs to continue operating in its current form while supporting the growth plan being presented. The appropriate level should align with the earnings of the business and the way it operates. To assess this, working capital is typically reviewed in relation to industry standards, financial and operational projections and typical bank covenant ratios.

What is considered an adequate amount of working capital?

Adequate working capital is often demonstrated by amounts that have been maintained consistently over time while still allowing shareholder distributions that do not need to be re-loaned to the company. Often, a business owner receives an annual bonus or dividend to reduce the company’s tax liability. The company then pays tax on a reduced level of income, and the shareholder pays tax on the amount received. The funds are then advanced back to the business so it can continue to operate. If this occurs repeatedly, it indicates that the business depends on shareholder loan capital to meet its ongoing working capital needs.

When distributions can be made and retained by the shareholder without being reintroduced into the business, it suggests that the company is operating from its own resources and has the capacity to distribute discretionary cash flow. This demonstrates that a business can distribute discretionary cash flow.

When is working capital considered insufficient?

Insufficient working capital can present itself in two ways. The first is straightforward and occurs when current liabilities exceed current assets, making it difficult for the business to meet short-term obligations. The second is less obvious. In this case, the business may still report positive working capital, but the level is not enough to support growth, new initiatives, or operational flexibility. As a result, the business is often forced to maintain the status quo rather than pursue expansion.

Evaluating surplus working capital

Surplus working capital is generally viewed as the amount above what is required to operate the business in its current state, without growing. If the EBITDA used in the valuation already reflects forecasted growth in EBITDA, then the working capital level should also be sufficient to support that growth. As the growth profile increases, the amount of working capital required often increases as well, which can reduce or eliminate what might otherwise appear to be excess.

Because no two businesses are exactly the same, the assessment of surplus or deficiency should consider a range of operational and financial factors, including:

• Industry benchmarks for well-performing companies
• The relationship between revenue and working capital
• Seasonal fluctuations in the business
• Capital for growth initiatives
• Inventory turnover
• Timing of collections on receivables
• Timing of payments to suppliers
• Access to cash or operating lines of credit
• Whether additional working capital is being used to achieve purchasing efficiencies

How working capital affects the sale price

Two businesses can have the same EBITDA and revenue yet produce very different outcomes once working capital is considered. In one case, a business carries more working capital than it needs to operate on a sustained basis, allowing the excess to be added to the purchase price and effectively increasing the seller’s realized multiple. In another, the business does not carry enough working capital to support normal operations, and the shortfall is treated as a reduction to value. Although both transactions may start with the same apparent valuation, the way working capital is positioned ultimately determines whether the seller captures additional value or unknowingly concedes it at closing.

The way working capital is managed and presented today has a direct impact on value at exit. You don’t have to be ready to sell to take the time to understand what level of working capital your business truly requires. It means you are putting yourself in a position to protect value, reduce friction in a future transaction, and negotiate from a position of strength.

Corporate Investment Business Brokers (CIBB), headquartered in Fort Myers and Sarasota, has been advising business owners through business sales for nearly 40 years. A working capital review or preliminary valuation discussion with our team can help identify potential risks and opportunities well before going to market. Contact us for a free, no-obligation business valuation estimate and gain clarity on how working capital may affect the value of your business.