What is Working Capital and How Does it Work in M&A Transactions?

Under generally accepted accounting principles (GAAP), working capital is defined as the difference between a company's current assets and current liabilities. It represents the short-term liquidity available to a business and measures its ability to cover its short-term obligations.

When purchasing a business, the purchase price includes its assets, and one of those assets is normalized working capital, often referred to as the working capital target or the peg. This peg is usually based on an average of historical working capital levels over a specified period.

The peg ensures that the buyer receives adequate working capital to operate the business and that the seller does not manipulate working capital levels, such as by accelerating receivable collections, delaying payables, and other actions.

In transactions, working capital is often handled through a purchase price adjustment. Just before closing, working capital will be estimated as of the closing date. The purchase price at closing will then be adjusted upwards for excess working capital over the target amount or downwards for deficient working capital under the peg. After closing, a reconciliation process will establish the actual working capital at closing and the final purchase price.

It's important to note that working capital is often a source of disputes post-closing, and the calculation may or may not include cash. Additionally, the definition under the purchase agreement will often vary from GAAP. Working capital analysis and the treatment of debt-like items at closing are often interrelated, so it’s crucial to clearly understand how each works in a transaction.