Working capital, in basic terms, is a measure of the liquidity of your business. It is what is available to support the regular demands of the business. Often defined as current assets minus current liabilities on your balance sheet, a positive amount of working capital demonstrates a business that can cover all of its current liabilities with assets that are readily available.
A negative amount of working capital can represent a company that has struggled with sales, has not received payments from its customers in a timely fashion or is not keeping up with accounts they owe money on. A high amount of working capital is not always a good thing as it can be indicative of too much inventory or inefficient investing of cash.
So how do you calculate working capital?
While the exact working capital calculation can vary drastically from business to business, it is an important point of consideration for both buyer and seller and should be defined early in the transaction process. Often the working capital of a business can be measured by calculating an average of the trailing twelve months assts and liabilities (or a selection of these accounts) and using that average measured against balance sheet figures pulled at closing. By calculating and establishing a working capital assessment based on an annual average, both the buyer and the seller have the ability to evaluate whether an adjustment needs to be made to this working capital number (the amount of capital needed to keep the current operations of your business operating smoothly) at the time of sale.
Perhaps a seller must make a large order of inventory right before your closing date but will not receive payment for that order before closing. With a higher than normal level of inventory (an asset) at closing, the seller should be made whole for this higher than normal conveyance of assets. In this scenario, the purchase price would be adjusted up to make up for the excess assets (inventory) being conveyed at the closing date. Alternatively, if the seller runs a liquidation sale right before closing and inventory is well below the normal level, the purchase price would be adjusted down to offset the lower than normal inventory amount.
Make sure you understand the working capital requirements of your business and what this means in your particular industry when it comes to a sale. Understanding these factors will help you decide the right time to sell your business and what will be required at closing.