What is Working Capital?
By Don Beezley © 2025
When working on a deal with our clients, we often find that “working capital” is one of the most elusive concepts for our clients to get their arms around. The textbook definition of working capital is the difference between Current Assets and Current Liabilities. That’s easy math to do. In most cases you would exclude cash since lower middle market deals will typically be “cash free” meaning the Seller keeps their cash on hand at the time of sale. Most offers will indicate that the offer is premised on “adequate working capital” being present in the business post-close.
Why is this the case? Working capital is important in the continuing operations of any business, and a Buyer’s offer will typically include it implicitly in their valuation. Cash is required for a business to operate to meet payroll, pay vendors, buy inventory, and any number of other short term/current payables and obligations. Current assets—those things such as Accounts Receivable that you will convert to cash in the relative short term (but always less than one year) are needed to meet the company’s obligations that also come due in that same period.
In the examples below, I treat it as though only A/R and A/P are the relevant working capital accounts for the sake of simplicity and clarity. In the real world it will most likely include things such as inventory and other Current Assets and Current Liabilities on your balance sheet, except for cash or bank or other such debt.
As a simple example, imagine you have $600,000 in obligations to meet each month and you have $1,000,000 in sales in a month, showing a $400,000 “profit,” but if the revenue doesn’t come in for 30 days, and the obligations are due before 30 days, you are short $600,000 even though you are very profitable. Your “working capital” is what covers that gap. The easiest example to continue on is the Accounts Receivable you would collect from the prior month’s sales, i.e., your Accounts Receivable in place at the beginning of the month provide the (working) capital to meet your operating needs for the month.
In the above example, this is your simplified balance sheet:
A/R $1,000,000
A/P $ 600,000
Working Capital $ 400,000
Let’s say your business has “EBITDA” (Earnings Before Interest Taxes Depreciation & Amortization) of $1,500,000 per year and I am paying you $6,500,000 for the business. My expectation is that when I take over the business post-close, I will also be taking on your A/R Balance of $1,000,000 and your A/P balance of $400,000—a net of $400,000. This is typically referred to in the LOI and/or Purchase Agreement as “Net Working Capital.” The $400,000 would be the Net Working Capital “Target” or “Peg.”
Where Sellers most often get confused with working capital is that they feel like “I generated that $1,000,000 in sales, so the A/R is mine.” As far as that goes, it’s true. However, if I take over the business day one at zero dollars in working capital, i.e., you keep your A/R and pay off your A/P, in that first “sales to cash “ cycle I have to go through with the business, I, as the Buyer, now have to fund a month’s expenses until I am “in flow” with the working capital cycle of the business thirty days later. As a result, I am not paying you $6,500,000 for the business, I am really paying you that plus one month’s expenses. The “price” plus having to replace a key asset—working capital –that you stripped out of the business. It’s no different than if I paid you $6,500,000 for a business with 10 heavy trucks worth $100,000 each and you decide to keep one. If I have to replace it, then I’m really paying you $6,500,000 + 100,000 or $6,600,000, not $6,500,000. What would actually happen, since I valued the business with that truck in place (just like I did working capital), if you keep it, I will reduce the price I am willing to pay by at least $100,000 to $6,400,000. On a $6.5mm purchase price, if you keep the net working capital of $400,000, then I’m reducing the price to $6,100,000.
“Net Working Capital” it is a key operating asset of the business essential to its ongoing operation as a going concern, just like a truck.
What happens at the time of sale?
A “Net Working Capital Target” or “Peg” is typically used in the agreement so no party can take advantage of the other. Continuing the above example, let’s assume net working capital averages $400,000 (often an average based on the prior 12 months) and that is the agreed upon target by both parties. When closing comes around, if that calculation nets $500,000 (maybe you used up some cash and paid down some payables more than usual, or you had a little higher sales so your A/R balance is a $100,000 higher than usual), then the Buyer would have to pay you an additional $100,000 for the “excess working capital.” Otherwise they are getting a $100,000 asset they didn’t pay for.
Likewise, the Seller can’t collect a bunch of extra A/R right before Closing (converting it to cash in their account) or artificially defer paying payables to force the Buyer take over higher payables than expected. If that happens and working capital (A/R – A/P in our simple example) is only $300,000 and the target is $400,000, the Seller will have to take that extra cash and transfer it to the Buyer to bring working capital up to the agreed upon target (Note: mechanically, it would usually just be a reduction to total proceeds received by the Seller at closing; Seller wouldn’t actually write a check to the Buyer; Seller would just get $100,000 less cash at Closing).
Other Adjustments
A twelve-month average, such as the “TTM”—Trailing Twelve Months—is a typical starting point to assess what is “fair” and appropriate for a given business’ working capital target. But a business may be seasonal, growing fast, or declining. As a result, a simple twelve-month average, may not be the best measure.
Final Notes
You should generally expect that a Buyer is including working capital in their valuation/offer unless they state otherwise. If it is unclear in an offer, it needs to be clarified before proceeding. The Buyer should include their analysis of working capital requirements in their due diligence process. But the Seller (and their advisors) also need to understand what is appropriate and why in order for the target to be set at an appropriate amount and not unfairly favor either. Negotiations can bog down on this issue, as it can represent a significant swing in what happens financially at Closing. It’s important to understand what it is, what accounts should be included in the calculation, and try to achieve a reasonable working capital target that is fair to both parties.
It’s also possible the adjustments noted above may happen post-close because it is sometimes not possible to know exactly what the balance sheet account balances are at closing. Most agreements will provide for a “true up” 60 – 90 days post close once the accounting through the closing date is fully closed out and cleaned up, then the parties will make an appropriate financial adjustment. That adjustment can take many forms from cash exchanging hands, to adjusting a seller carry note up or down, if there is one, or possibly tapping a working capital or indemnity escrow fund if one is in place.
Don Beezley is President of Proforma Partners, LLC and a Business Certified Appraiser (BCA) with over three decades of M&A, banking, and business operations experience.