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Buyer’s side: the importance of working capital definitions as part of due diligence

Article written by Greg Shagalovich, CPA at Segal GCSE LLP, for the Quarterly Canadian Update, a newsletter published by
Canadian member firms
of
Moore North America
. This article on the importance of working capital definitions in due diligence is part of our mission to be your partner in success by keeping you informed.

Buyer’s side: the importance of working capital definitions as part of due diligence

The process of acquiring a company is a lengthy one, but when completed successfully, it has no significant impact on the company’s normal activities. As many transactions take place without cash or debt, the post-closing balance sheet must reflect the true nature of the company’s working capital, which differs from the traditional accounting-centric definition. Consequently, understanding the working capital cycle of a target company is an essential element in helping your client negotiate a fair transaction and ensure a smooth transition of control.

The type of agreement described above usually begins with a letter of intent, in which it is stipulated that the seller must leave an appropriate amount of working capital in the business to ensure that it continues to operate without interruption. As the deal nears completion, it’s essential to set a clear working capital target and definition for the purchase agreement, to avoid undefined liabilities becoming the responsibility of the buyer.

Thus, the working capital related to the operation may be made up of all or only some of the following balances:

  • Receivables net of provisions for doubtful debts;
  • Inventory;
  • Prepaid;
  • Non-income taxes receivable;
  • Accounts payable and accrued liabilities;
  • All other accruals (e.g. salaries, vacation, etc.);
  • Taxes not related to income payable;
  • Deferred income (if not included in indebtedness in the purchase contract).

It is possible to determine which of the above are the case by exercising due diligence. The common steps to achieve this are as follows:

  • Understand the target company and whether its working capital is cyclical, and talk to management;
  • Understand the accounting policies in place and ensure that proper accrual accounting is followed. This is particularly important for interim periods if the target company does not keep regular accounts;
  • Analyze the quality of accounts receivable, the saleability of inventory and the appropriateness of prepayments to ensure that good assets remain on the balance sheet;
  • Follow correct cut-off and accrual procedures at the end of the period, to avoid unrecorded debts appearing after closing.

A well-understood and well-defined working capital target should ultimately put buyer and seller on an equal footing. The difference between target working capital and post-closing working capital (a period defined in the purchase contract to allow the books to be cleaned up after the acquisition) ultimately results in a downward or upward adjustment to the purchase price, where both parties need to feel comfortable with the deal you’ve helped advise them on.

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