Working Capital

What is working capital?

Working capital (net current assets, also called operating capital) is the part of current assets that is not financed by short-term liabilities. Current assets comprise the assets that are meant to turn into cash in the short term: inventories, trade receivables and bank balances. On the balance sheet, working capital is the difference between current assets and short-term liabilities.

In corporate management and in company acquisitions, the narrower measure is usually used, operating net working capital (Net Working Capital). It comprises inventories and trade receivables less trade payables and other operating items, excluding cash and financial debt. In simple terms, it is the money tied up in goods in stock and in customer invoices not yet paid, less what the company still owes its suppliers.

The measure shows how much capital is tied up in the ongoing business before services turn into cash receipts. It is derived from the balance sheet, planned in the financial model as a change in cash flow, used by banks when sizing working capital loans, and analysed in depth in financial due diligence. In the company purchase agreement, working capital is one of the figures that directly changes the purchase price.

Calculating working capital: formulas

Balance sheet working capital

According to Section 266(2) of the German Commercial Code (Handelsgesetzbuch, HGB), current assets comprise inventories, receivables and other assets, securities, and cash in hand and bank balances. Liabilities with a remaining term of up to one year are deducted from them. The figure is the absolute counterpart of third-degree liquidity and is used in credit assessment as a measure of whether short-term assets cover short-term debts. Expressed as a ratio, current assets divided by short-term liabilities, it is called the working capital ratio or current ratio. It is only of limited use for management purposes because it includes cash and bank debt.

Formula: Working capital = Current assets − Short-term liabilities

Operating net working capital

Operating net working capital is limited to the items that arise from the operating process:

• Asset side: inventories, trade receivables, prepayments made, other operating assets and prepaid expenses (deferred items).
• Liability side: trade payables, prepayments received, short-term operating provisions and liabilities, for example towards employees, and deferred income.
• Not included: cash, bank liabilities, shareholder loans and, as a rule, income taxes. These items belong to net debt (financial debt less cash) or are treated separately.

Formula: Net working capital = Inventories + Trade receivables + Other operating assets − Trade payables − Prepayments received − Other operating liabilities

Set in relation to revenue, the result is the working capital to revenue ratio, which is not to be confused with the working capital ratio (current ratio). Expressed in days, the cash conversion cycle describes the same tied-up capital as the period between payment to suppliers and payment by customers.

Working capital and growth

With positive working capital, every additional unit of revenue ties up capital before it leads to cash receipts. If inventories and receivables grow with revenue, the funding need rises even when the company is operating profitably. This explains why growth companies reach the limits of their liquidity despite good margins. Negative working capital, for example through advance payments by customers, works the other way round: growth releases funds.

Working capital is typically financed in the short term, through an overdraft facility, through supplier credit or through the sale of receivables (factoring). In a funding round, the working capital requirement is a separate item in the use of proceeds. Investors examine the ageing structure of receivables, the days of inventory cover (inventory turnover) and the adequacy of valuation allowances, that is, deductions for doubtful receivables and slow-moving goods. Without such deductions, overdue receivables and slow-moving stock overstate the reported working capital.

Working capital in company acquisitions

Company acquisitions are usually agreed on a cash-free and debt-free basis: financial debt is deducted from the enterprise value and cash is added to arrive at the equity value. This calculation assumes that the company is handed over with a normal level of working capital. An unusually low level on the reference date would force the buyer to inject its own funds after closing.

The parties therefore agree a normalised target value, often the average of the last twelve months, so that seasonal fluctuations are smoothed out. In a purchase price adjustment based on accounts drawn up after the closing date (completion accounts), the deviation of the actual value from the target value is settled through the working capital adjustment. Under the locked box mechanism, by contrast, a fixed purchase price applies on the basis of an earlier balance sheet. The working capital at that date is reflected in the price, and the buyer is protected by the prohibition of value leakage to the sellers.

Boundary with net debt

Negotiation focuses above all on the allocation of individual items. Overdue supplier liabilities, prepayments received for services not yet rendered, tax liabilities or provisions for bonuses can be treated as working capital or as debt-like items. Debt-like items are deducted from the purchase price in the same way as financial debt. Every allocation shifts value between the parties and must be worded so that no item is counted twice or not at all. Measures by the seller shortly before the reference date usually have a neutral effect: if receivables are collected faster, cash rises, working capital falls, and the purchase price ends up unchanged.

Worked example: calculating working capital and net working capital

A trading company with annual revenue of EUR 4.0 million reports the following on the reference date: inventories EUR 600,000, trade receivables EUR 500,000, other operating assets EUR 50,000, cash EUR 350,000. Falling due in the short term are trade payables of EUR 300,000, prepayments received of EUR 100,000, other operating liabilities of EUR 150,000 and a bank loan of EUR 250,000.

• Current assets: 600,000 + 500,000 + 50,000 + 350,000 = EUR 1,500,000
• Short-term liabilities: 300,000 + 100,000 + 150,000 + 250,000 = EUR 800,000
• Balance sheet working capital: 1,500,000 minus 800,000 = EUR 700,000
• Operating net working capital excluding cash and bank loan: 1,150,000 minus 550,000 = EUR 600,000
• Working capital to revenue ratio: 600,000 / 4,000,000 = 15%
• Growth to EUR 6.0 million revenue at the same ratio: 6,000,000 × 15% = EUR 900,000, additional capital requirement EUR 300,000

If the company is sold and a target value of EUR 600,000 has been agreed, a reference-date value of EUR 540,000 reduces the purchase price by EUR 60,000. The reconciliation also shows why the two definitions must not be mixed: the cash of EUR 350,000 and the bank loan of EUR 250,000 already enter into net debt.

Distinctions: working capital, current assets and net debt

• Current assets: the gross figure on the asset side of the balance sheet. Working capital deducts short-term financing from it.
• Cash conversion cycle: describes the capital tied up in days instead of euros.
• Working capital adjustment: the mechanism in the purchase agreement that translates deviations from the target value into a purchase price adjustment.
• Net debt: financial debt less cash. It is deducted from the enterprise value, whereas working capital acts through the target value. Every item belongs in exactly one of the two figures.

Common mistakes

• Growth planned without working capital. A financial model that only extrapolates revenue and margin underestimates the capital requirement as soon as inventories and receivables grow with it.
• Cash included. In company acquisitions, cash is captured through net debt. If it also appears in working capital, it is counted twice.
• Target value taken from a single reference date. In seasonal businesses, a single reference-date value produces a target value that does not correspond to normal requirements.
• Receivables without ageing analysis. Overdue receivables without an adequate valuation allowance raise working capital on paper and are written down in due diligence.
• Inconsistent accounting. If the reference-date value is determined under different principles from the target value, a purchase price adjustment arises without any economic reason.

Frequently asked questions

How is working capital calculated?

Current assets minus short-term liabilities. In company acquisitions, operating net working capital usually counts: inventories and trade receivables minus trade payables and prepayments received, excluding cash and bank debt. In the worked example, this gives EUR 700,000 on a balance sheet basis and EUR 600,000 on an operating basis.

What is the difference between working capital and current assets?

Current assets are only the asset side. Working capital deducts short-term liabilities from them and shows which part of current assets has to be financed with longer-term capital.

Is negative working capital a bad sign?

Not necessarily. If it is based on advance payments by customers, the business partly finances its own growth. It is a concern if it arises from overdue supplier invoices.

How is the target value in the purchase agreement determined?

As a rule, from the average of the monthly values of the last twelve months, adjusted for one-off effects and prepared under the same accounting principles that apply to the reference-date value. The derivation usually comes from the financial due diligence.

What is working capital management?

The management of inventories, receivables and trade payables with the aim of tying up little capital without endangering the ability to deliver or customer relationships. Starting points are faster invoicing, a binding dunning process, inventory levels linked to actual consumption and negotiated payment terms in purchasing. Invoicing is entirely in the company's own hands and therefore has the fastest effect.

The Roemer Capital view

In sell-side mandates, Roemer Capital defines working capital before the first offers arrive. This includes which items count, how the target value is derived and where the boundary with debt-like items lies. If this is negotiated only in the purchase agreement, the sellers are under time pressure and the buyer already knows the figures from due diligence.

In growth financings, Roemer Capital calculates the capital requirement arising from working capital separately. Part of it can often be financed through working capital lines or factoring, without giving up shares.