Working Capital Adjustment

What is a working capital adjustment?

Working capital adjustment (German: Anpassung des Nettoumlaufvermögens) is the change to the purchase price in a company acquisition by the amount by which net working capital on the closing date deviates from a contractually agreed target value. In simple terms, net working capital is the capital tied up in day-to-day business: inventories and outstanding customer receivables less outstanding supplier invoices. If the actual value is above the target value, the purchase price rises; if it is below, the price falls, as a rule euro for euro.

Formula: Adjustment amount = Net working capital on the closing date − agreed target value

A similar rule applies to a rental car: a particular fuel level is agreed, and if fuel is missing on return, the difference is charged. The adjustment is part of the purchase price adjustment based on accounts drawn up after the closing date (completion accounts) and is settled together with financial liabilities and cash. It occurs in a share deal as well as in an asset deal (asset purchase agreement); there, it covers only the items that are transferred. The agreed enterprise value assumes that the company is handed over with the current assets it needs for ongoing operations. The buyer has to finance a shortfall after closing, while an excess brings additional liquidity as soon as it is run down. Under the locked box mechanism, the subsequent adjustment does not apply.

What counts as net working capital in a working capital adjustment

The term does not coincide with the current assets shown on the balance sheet under Section 266(2) of the German Commercial Code (Handelsgesetzbuch, HGB). The latter also includes cash in hand and bank balances and does not deduct any liabilities. For the purchase price adjustment, only operating net working capital counts, in financial analysis also called working capital. It typically comprises:

• on the asset side, inventories, trade receivables, other operating assets and prepaid expenses (deferred items)
• on the liability side, trade payables, prepayments received, deferred income, other operating liabilities and short-term operating provisions, for example for holiday entitlements or outstanding invoices

Cash and financial liabilities, which appear separately in the purchase price formula, are not included, nor are items treated as debt-like. Income tax items are often taken out and captured as debt-like items or through a tax indemnity. Every balance sheet item must be allocated to exactly one category, otherwise it is counted twice or not at all.

The separation from liquidity explains why the adjustment neutralises arrangements made before closing. If the seller collects receivables early, cash rises and with it the purchase price; however, net working capital falls by the same amount, and the purchase price falls accordingly. The same applies if supplier invoices are paid later or inventories are run down. Without this adjustment, the seller could draw liquidity out of the company in this way, which the buyer would then have to replace.

The target value: normalisation, seasonality and growth

The target value (target working capital, also called the peg in the market) is meant to reflect the level that the business needs in normal operation. The average of the monthly values of the last twelve months is widespread, adjusted for special effects such as a one-off build-up of inventory, an exceptional advance payment or the loss of a major customer.

In seasonal businesses, net working capital fluctuates considerably over the year, and liquidity moves in the opposite direction: a seasonal build-up of inventory is paid for from bank balances or through the credit line. With an annual average as the target value, the two effects largely offset each other in the purchase price. In this situation, buyers sometimes propose a month-specific target value, because the business needs the high inventory at that time of year anyway. This is consistent only if the seasonal financing is also balanced out, for example through a correspondingly adjusted net debt. Otherwise, the closing month alone decides part of the proceeds.

In growing companies, the value on the closing date is regularly above the average of the past; whether the additional inventory is compensated or the target value takes the growth trend into account must be regulated expressly. The target value must also fit the valuation. If the enterprise value is based on a business plan that assumes a certain level of inventories and receivables, that level is the appropriate yardstick. A target value significantly above the historical normal level works like a retrospective discount on the enterprise value.

Points of dispute in the determination

Customer prepayments

Software with subscriptions invoiced annually in advance gives rise to high prepayments. Under the HGB, they appear as deferred income (Section 250(2) HGB) or as prepayments received; in Anglo-Saxon usage, they are called deferred revenue. As liability items, they reduce net working capital, which is therefore often negative in such business models.

Buyers argue that they have to render the service that has been paid for without receiving any more money for it, and want to deduct the item as debt-like. Sellers counter that a normal level of prepayments is part of the business model and is already included in the target value. If the item is carried in net working capital and also deducted as debt-like, it reduces the purchase price twice. The solution is either to capture it in net working capital with a normalised target value or to deduct only the costs that will still be incurred to deliver the prepaid service.

Overdue receivables and inventories without movement

Under the lower-of-cost-or-market principle of Section 253(4) HGB, receivables and inventories must be recognised at the lower fair value. This opens up discretion that has a direct effect on the purchase price. Contracts therefore lay down fixed rules, for example flat-rate valuation allowances by days overdue or write-downs for inventories that have not moved for a certain number of months.

Accruals in the monthly values

Holiday provisions and outstanding incoming invoices are often recorded completely in the ongoing bookkeeping only at year end. If they are missing in the monthly values from which the target value is calculated but not in the closing accounts, net working capital falls purely because of the different recording.

Structuring the working capital adjustment in the purchase agreement

• Euro-for-euro adjustment: every deviation is compensated in full in both directions.
• Corridor: deviations within a band around the target value are disregarded. Structured as a deductible, only the part outside the corridor is settled; structured as a tipping threshold, the entire deviation is settled as soon as it leaves the corridor.
• One-sided adjustment: only a shortfall against the target value reduces the price. Buyers propose this, sellers generally reject it because an excess then remains uncompensated.

Worked example: working capital adjustment in a seasonal business

A manufacturer of heating components with a pronounced autumn business is sold as of 30 November. The contract provides for a euro-for-euro adjustment. The target value is based on the monthly values of net working capital from October to September before signing. The company finances the seasonal inventory build-up through its credit line.

• Monthly values in EUR million: 4.3; 4.5; 4.0; 3.5; 3.3; 3.4; 3.6; 3.8; 3.7; 3.4; 3.6; 3.9; total 45.0; average 45.0 divided by 12 = EUR 3.75 million
• Special effect: in October and November, inventories included stock for a one-off large order of EUR 0.6 million each
• Normalised average: (45.0 minus 1.2) divided by 12 = EUR 3.65 million
• Actual value according to the closing accounts as of 30 November: EUR 4.1 million
• Net debt as of 30 November: because of the seasonal financing, EUR 0.45 million above its annual average; this amount reduces the purchase price
• Variant A, annual average as the target value: 4.1 minus 3.65 = EUR 0.45 million, the purchase price rises by EUR 450,000. Together with the deduction for the higher debt, the seller receives as much as with a closing in an average month
• Variant B, seasonal target value from the normalised November value of the previous year: 4.5 minus 0.6 = EUR 3.9 million; adjustment 4.1 minus 3.9 = EUR 0.2 million. After the deduction for the higher debt, the seller receives EUR 250,000 less than with a closing in an average month
• Difference between the variants: EUR 250,000, solely through the definition of the target value
• With a corridor of EUR 100,000, only EUR 100,000 would be settled in variant B as a deductible, but the full EUR 200,000 as a tipping threshold

As long as debt is measured on the closing date as usual, the annual average makes the proceeds largely independent of the closing month. The month-specific target value shifts the seasonal financing requirement onto the seller.

Distinctions: working capital, purchase price adjustment and transfer pricing

• Working capital: the key figure for the capital tied up in the operating business. The working capital adjustment turns it, with contractually defined items and rules, into the basis of a price adjustment. In the cash flow statement, by contrast, the change in working capital appears as a reconciling item to operating cash flow.
• Post-closing purchase price adjustment: the procedure after closing in which all adjustment items are determined, including net working capital.
• Net debt: financial liabilities less freely available cash. It is usually the largest item in the bridge from enterprise value to equity value (equity bridge). It is recorded separately but has to be considered together with net working capital, because changes in one figure are usually mirrored in the other.
• Working capital adjustment in transfer pricing: a comparability adjustment of the same name in international tax law. It eliminates differences in working capital between group companies and independent comparable companies, without any connection to a purchase price.

Common mistakes

• Inconsistent determination. If the target value and the actual value are calculated under different definitions or delimitations, an adjustment arises that does not reflect any economic change.
• Special effects not adjusted. A one-off inventory build-up or an exceptional advance payment in the reference period distorts the average and with it the target value.
• Seasonality viewed one-sidedly. Anyone who ignores seasonally fluctuating liquidity easily chooses a target value that benefits one side purely through the closing month.
• No fixed valuation allowance rules. Without contractual percentages for overdue receivables and inventories without movement, the preparer of the closing accounts shifts the price through discretion.
• Growth not regulated. If the level on the closing date is above the average because of growth, it remains open without a rule whether the buyer compensates the additional inventory.

Frequently asked questions

How is the working capital adjustment calculated?

As the difference between net working capital according to the closing accounts and the agreed target value. With an actual value of EUR 4.1 million and a target value of EUR 3.65 million, the purchase price rises by EUR 450,000. Cash does not count; it appears separately in the purchase price formula.

How is the target value for net working capital set?

Usually as the average of the monthly values of the last twelve months, adjusted for special effects. In seasonal businesses, month-specific target values occur; the measurement of net debt must then fit. The target value appears as a fixed amount in the purchase agreement.

Is there a working capital adjustment with a locked box as well?

No. With a locked box, the price is fixed at signing. If net working capital in the locked box balance sheet deviates from the usual level, the parties take this into account once in the price negotiation.

Is negative net working capital a problem?

Not necessarily. In business models with prepayments it is usual, because customers pay before the service is rendered. For the adjustment, the sign is not what counts but the deviation from the target value, which can then also be negative.

The Roemer Capital view

In sell-side mandates, Roemer Capital derives the target value from the same monthly accounts on which the financial model and the valuation are based. This makes it possible to show buyers that the target value corresponds to the level that the enterprise value presupposes, and special effects are adjusted before the other side raises them in due diligence.

For software companies with prepayments, Roemer Capital clarifies the treatment of deferred income already at the offer stage, because its classification can shift the proceeds by an amount in the order of magnitude of the entire item. Where Roemer Capital acts as an interim finance function, the monthly accounts are set up from the outset with complete accruals; this makes the time series reliable for buyers.