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What is the Right Amount of Working Capital to Include in a Business Sale?

How do you determine the "right" amount of working capital when buying or selling a business? Do you leave it up to the SBA lender to decide? Do you take the seller's or buyer's word for it? Is there a formula to figure it out?

While small business owners understand the need for working capital, determining how much is needed for the operating cycle is sometimes a mystery. When I was a commercial lender, I remember discussions with business owners asking for a $1,000,000 credit line for working capital purposes, when in reality they needed only $500,000 to fund the operating cycle and a $500,000 term loan to replenish the working capital (i.e., cash) spent on equipment acquisitions.

Commercial lenders want to make sure that the loan purpose matches the loan need. Operating assets such as accounts receivable and inventory are short term, where equipment and vehicles are considered long term assets. Long term assets are typically financed over a longer period due to the tangible nature of that asset. For example, when you purchase a piece of business equipment or a vehicle, the payback term can be up to 60 or 72 months depending on the asset.

A Better Working Capital Formula

When selling or buying a business, an important analysis is determining the "right amount" of working capital used for operations. Back in my commercial lending days, I learned a formula that we called the "Financing Gap". This formula indicated the amount of working capital needed during a company's cash cycle as determined by the "turn days". Turn days refers to the collection time period of accounts receivable, turnover of inventory (if any) and number of days used to pay the accounts payable.

Why did we call it the "Financing Gap"? Because the number of days between the receipt of cash by the business (sales and collection of Accounts Receivable) and cash going out (payment of expenses and costs) is the period of time that the company must cover its operations - either from internally generated cash or from a credit line provided by a lender. While the "Financing Gap" isn't a definitive approach because of the dynamic nature of business operations, it is a useful tool to determine a company's likely working capital needs.

Determining the "Right Amount" of Working Capital

Traditional Formula: Current Assets Less Current Liabilities

The technical definition of Working Capital is the difference between Total Current Assets and Total Current Liabilities. To get the most accurate picture of Working Capital, any non-current assets and non-current liabilities should be removed from the calculation even though the business financial statements may show them in that category. In this example, let's look at a snapshot of the last three years' Income Statements and the Balance Sheets.

Financing Gap Analysis

The Total Working Capital amount shown above is the difference between Current Assets and Current Liabilities. This simple formula does not necessarily provide the details that you need to really understand the Company's true Working Capital requirements. To get started, let's dive into some calculations.

1. Calculate Accounts Receivable Turns

a. Sales (Revenues)/Accounts Receivable: Divide Sales by Trade Receivables

Example: $1,000,000/$100,000 = 10

This ratio measures the number of times receivables turn over during the year. In this example, the receivables turn over 10 times. The higher the turnover, the shorter the time between sale and cash collection. The challenge with this ratio is that it compares one day of receivables as shown on the balance sheet to Total Sales which have been generated over the period, which in this case is 12 months. Also, this ratio does not account for seasonal fluctuation. An additional situation to consider is if there is a large proportion of cash sales to total sales.

b. Convert the Accounts Receivable Turns Into Days

Divide the Sales/Receivable ratio into 365 (the number of days in one year, if you are using year end statements).

Example: 365/10 = 37 (rounded up to 37)

This figure of 37 represents the average number of days that accounts receivable are outstanding. Generally, the larger number of days outstanding, the higher probability of delinquencies and may indicate the quality of the business's collection efforts. However, it may also indicate the company offers longer terms to its customers. So doing a deeper dive and asking questions is important.

2. Calculate the Inventory Turns

a. Divide Cost of Goods Sold by Inventory

Example: $500,000/$100,000 = 5

This ratio measures the number of times inventory has "turned over" (been sold and replaced) in a year. In this example, inventory turned over 5 times. High inventory turnover can indicate greater liquidity. Low inventory turns may mean excess inventory or "dead" inventory that has never sold. On the positive side, it could mean the business is stocking up for a busy season.

The caution about this ratio is that it compares a snapshot of one day's inventory balance to the annual Cost of Goods sold and doesn't take any seasonal fluctuations into account. Again, good questions to ask include: Tell me about your inventory management process. How do you track and control inventory? How often are counts done and adjustments made? Any seasonal buying or stocking up due to supply chain issues?

b. Convert the Inventory Turns Into Days

Divide the inventory turns into 365.

Example: 365/5 = 73 days

This indicates the average number of days that the company has inventory in its possession.

3. Calculate the Accounts Payable Turns

a. Divide Cost of Goods Sold by Accounts Payable

Example: $500,000/$30,000 = 17

This ratio measures the number of times a company's trade payables turn in the selected period. The higher the turnover, the shorter the time between the company's purchase materials and goods and its payment to vendors. As with the other calculations, this ratio uses one days' view of accounts payable and compares it to the total Cost of Goods Sold which in this case is one year. It does not take seasonal fluctuations into account. So, again, you'll need to ask questions if the payables seem abnormally high.

b. Divide the Accounts Payable into 365

Example: 365/17 = 21 days

This yields the average length of time the company has trade debt outstanding. If a company buys on 30-day terms, it is reasonable to expect 30 days outstanding.

4. Putting it Together - The Financing Gap

The turn days below were calculated using the example financials shown above. The Financing Gap is the sum of Accounts Receivable Days plus Inventory Days minus Accounts Payable days.

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