In the article on net debt I wrote that the price of a company is decided in the definitions of the contract, and that December net debt is the prettiest of the year because in November everyone collects receivables and runs down inventory. What is missing is the other half of the bridge, the one that closes the circle: working capital. Because the million the seller frees up in December does not disappear. It changes line, and on the new line the buyer is waiting for it.
What working capital is, explained with a bar
Net working capital is the money a company has to keep tied up to operate: the invoices customers will pay in ninety days, the goods in the warehouse, minus the invoices you will pay suppliers in sixty. Receivables plus inventory minus payables. Think of a bar: you buy the place, but if the next morning the till is empty and so are the shelves, you have to put your own money in before you sell the first coffee. That money is working capital. A company with twelve million of revenue and receivables worth about a hundred and ten days of sales keeps three point six million tied up in unpaid invoices alone.
Why it matters as much as net debt in a transaction
A cash-free debt-free offer assumes the company is handed over with a normal level of working capital, the level it needs to keep operating the day after closing. If working capital at closing is below normal, the buyer will have to put cash back in, and deducts it from the price euro for euro. If it is above normal, the seller pockets the difference. The full bridge becomes: Equity Value equals Enterprise Value, minus net debt, plus the difference between actual and normal working capital. That normal level is called the peg (or target working capital), and it is the number that gets negotiated.
There is a link few people see: net debt and working capital are the same cash seen from two sides. When you collect an invoice, cash goes up, so net debt goes down, and receivables go down, so working capital goes down. You cannot win twice. The million that makes December net debt look good is the same million missing from working capital, and if the contract has both adjustments it comes back in full.
How the normal level (peg) is set
The starting point is the average of the monthly balances over the last twelve months, not the year-end figure. Then you correct for three things: seasonality (if closing falls in a peak month, the normal level is that month’s level in previous years), growth (working capital grows with revenue, so for a fast-growing company the latest months weigh more) and one-off events, such as an unusual order or a supplier paid in advance.
Finally you clean it. Receivables overdue for too long come out: in due diligence you look at the ageing, and beyond 180 days the probability of collection collapses. Slow-moving or obsolete inventory is written down. Suppliers paid beyond twelve months are no longer working capital but financing, and move into net debt: that is row K from the other article. Those merely stretched, 120 days where the sector pays at 60, stay in working capital, but the buyer will try to treat them as a debt-like item. Golden rule: every balance sheet item sits in one box only, net debt or working capital, never in both and never in neither. Factoring is the classic example: either you treat it as debt in net debt, or you put the sold receivables back into working capital. Not both.
The example in numbers
I take the imaginary company from the other article: twelve million of revenue, EBITDA 1,800, Enterprise Value 10,800 at 6.0x (thousands of euro).
| €k | 12-month average | 31 December |
|---|---|---|
| Trade receivables | 3,600 | 2,900 |
| Inventory | 1,900 | 1,500 |
| Trade payables | (2,200) | (2,200) |
| Reported working capital | 3,300 | 2,200 |
| Receivables overdue beyond 180 days | (150) | (150) |
| Slow-moving inventory | (120) | (120) |
| Payables beyond one year, reclassified to net debt (row K) | 200 | 200 |
| Normalized working capital | 3,230 | 2,130 |
The peg is 3,230, working capital at closing is 2,130: price adjustment minus 1,100. In December the seller collected 700 more receivables than average and sold 400 of inventory without replacing it: cash rose by 1,100, net debt fell by almost as much (that is the million-plus, 1,088 to be precise, that separated the average from the December snapshot in the other article) and working capital fell by 1,100. The full bridge:
| Bridge to equity | €k |
|---|---|
| Enterprise Value (1,800 × 6.0x) | 10,800 |
| less adjusted base net debt | (4,680) |
| plus (working capital at closing minus peg) | (1,100) |
| Equity Value | 5,020 |
In the seller’s head, reasoning with pure ESMA net debt at December and no working capital adjustment, equity was 7,305. The full bridge says 5,020: 2,285 less, 21% of the Enterprise Value, without even touching TFR and factoring.
Locked box and completion accounts, on the working capital side
With completion accounts the working capital adjustment is made after closing on actual figures, usually with a collar, a tolerance band around the peg inside which nothing is adjusted, so nobody litigates over pennies. With a locked box there is no adjustment: the normal level has to be priced beforehand, on the reference balance sheet, and the buyer protects itself with leakage clauses. In both cases the real work is the normalization, and due diligence does it.
Three moves. If you are buying, ask for monthly working capital over the last twenty-four months and agree the peg and the definitions of net debt and working capital together, in a single table. If you are selling, do not squeeze December: the buyer hands it back to you as an adjustment, and in the meantime you have burned credibility. In both cases, every item in one box only.
The photo and the film
As an entrepreneur I understand the temptation: reaching 31 December with cash in good order is satisfying, and the bank needs it. But a company is not sold with a photograph, it is sold with a twelve-month film, and the film is watched by people paid to notice the cuts. I have learned that working capital managed well all year is worth more than any year-end trick, because it is the only thing no due diligence can deduct from you, and it is also what lets you sleep better in June. It is the boring fundamental you neglect while polishing what you already feel good at, and that is how a strength turns into a blind spot. If tomorrow you had to hand over the film and not the photo, what would you change in the way you manage receivables, inventory and suppliers?
Sources: ESMA Guidelines ESMA32-382-1138 for row K; art. 2424 of the Italian Civil Code (assets C.I inventory and C.II receivables, liabilities D7 trade payables). This is not legal or tax advice: on a real deal the peg and the definitions are written by a professional with the contract in front of them.
