Understanding the Impact of Working Capital on Equity Value in M&A

What is working capital in M&A?

While the textbook definition of working capital is typically current assets (including cash) minus current liabilities, in Mergers & Acquisitions and corporate finance, it reflects the money tied up in day-to-day operations (i.e. operating working capital, which excludes cash).

Key considerations in transactions

To facilitate a smooth sale process, it’s essential that the relevant parties reach an agreement on the following:

• Defining the ‘normal’ working capital cycle: Understand the typical operating cycle for the business.
• Identifying working capital balances: Decide which balances qualify as working capital.
• Normalising working capital: Adjust for atypical items to reflect normal trading conditions.

Why is working capital important in M&A?

Working capital can be a significant value driver in a deal.

Transactions are usually agreed on a “cash-free, debt-free” basis, meaning the enterprise value (EV) is adjusted euro-for-euro for cash and debt at completion. It’s assumed the business will be delivered with a ‘normal’ level of working capital. A working capital adjustment ensures this by comparing actual working capital delivered to the agreed target, with any shortfall or surplus adjusted from the purchase price.

Defining ‘normal’ working capital

The ‘normal’ level – often called the Target or Peg – is defined in the Share Purchase Agreement (SPA). This figure is the benchmark against which ‘delivered’ working capital is compared against, resulting in a positive or negative adjustment for the seller.

Because accounting standards don’t explicitly define these terms, determining what constitutes ‘normal’ and which items count as working capital is often open to interpretation. This can result in significant value swings.

In stable businesses, a 12-month average is often used to capture seasonal fluctuations. For fast-growing companies with positive working capital cycles, a shorter period may be more appropriate to avoid understating the Peg.

Identifying working capital balances

Typical balances include trade debtors, trade creditors, stock, VAT and payroll tax liabilities. However, depending on deal specifics, the treatment of items such as customer deposits, deferred revenue, tax liabilities and accrued compensation can be contentious.

Normalising working capital

Once balances are agreed upon, adjustments will be made to reflect normal operating conditions. Common adjustments include:

• One-off or non-recurring items
• Changes in accounting policies
• Overdue receivables or payables
• Related-party transactions

Case Study: Deferred Revenue Dispute

Take ABC Ltd., a construction company valued at 7x FY25 EBITDA of €6m. While the buyers and sellers align on most balance sheet items, they disagree on the treatment of deferred revenue.

Background: ABC invoices customers in advance for work not yet performed. Revenue is initially deferred and released as the job progresses.

• Buyer’s View: Treats settled deferred income as debt-like, arguing it may be repayable if the work is not completed.
• Seller’s View: It is treated as working capital, given that it arises during the normal course of business.

Impact: The disagreement creates a €1.6m swing in the equity value based solely on the treatment of this item.

How to avoid deal disruption

Early negotiation is key. In this case, advisors could have addressed the treatment of deferred revenue in the process letter, asking bidders to declare any differing views in their indicative offers. If a disagreement arises later, a practical compromise may involve segmenting deferred revenue, e.g., treating recurring contracts as working capital and non-recurring ones as debt.

Optimising Working Capital Before a Sale

To minimise disputes and maximise value, management should focus on working capital well before going to market. While growth and cost control often take priority, efficient working capital management is equally important.

Simple but effective steps include:

• Tightening credit controls and collecting overdue debts.
• Managing slow-moving inventory.
• Optimising supplier payment terms.
• Clearly defining normalised working capital ahead of the process.

How Forvis Mazars can help

Working capital adjustments can significantly impact deal value. With clear definitions, early alignment, and proper preparation, sellers can reduce friction and enhance outcomes. Our Corporate Finance advisors address these considerations early to help clients realise maximum value and drive successful transactions.