Working capital normalisation: how we compute the target.
Our FDD practice, in detail.
1. Why normalise.
Most M&A transactions deliver the target on a "cash-free, debt-free, with a normal level of working capital" basis. The agreed price assumes the business is being handed over with the working capital it needs to operate. If the actual working capital at closing is below the agreed target, the price reduces dollar-for-dollar; if it is above, the price increases.
The target is the linchpin. Set it too low, the seller transfers value to the buyer by leaving more working capital than agreed (and is not paid for it). Set it too high, the seller is penalised at closing for the deficit. A well-constructed working-capital analysis is therefore worth its weight in the deal economics.
2. The working-capital definition.
The first task is to define what is in and what is out of "working capital" for this transaction. Standard inclusions:
- Trade receivables (net of expected credit losses).
- Inventory (net of obsolescence provisions).
- Other current assets, except cash and cash equivalents.
- Trade payables.
- Accrued expenses, GST payable, TDS payable, statutory dues.
- Other current liabilities, except short-term borrowings and items classified as debt-like.
Items excluded from working capital are typically included in net debt or treated as debt-like. The line between "operating working capital" and "debt-like" matters because both schedules feed into the SPA from opposite directions.
3. Method: 12-month trailing average.
The standard normalisation is a 12-month trailing average of net working capital at month-end:
- Compute net working capital at the end of each of the last 12 months.
- Average across the 12 month-ends.
- The average is the target, subject to seasonality and exclusion adjustments.
The 12-month period is chosen because it captures a full operating cycle, including any seasonal swings, and it is short enough to reflect the current state of the business.
Where the business is growing rapidly (or shrinking), the average needs adjustment. A common approach is to use a months-of-sales metric (e.g. days sales outstanding, days inventory) at the average level and apply it to the current month's run-rate sales to compute the target at the current scale.
4. Seasonality adjustment.
For businesses with strong seasonality (festival peaks, agricultural cycles, project-based revenue), the 12-month average can mask the true working-capital need at the closing date. Two adjustments:
- Closing-month proxy. Identify the same month from prior years and use that month's working capital as the target, adjusted for growth. For a closing in November, look at the last three Novembers and use the working capital level appropriate for that period of the year.
- Rolling seasonally-adjusted average. Compute the 12-month average for each closing-month historical equivalent. This smooths out one-off effects in any single year.
Whichever method is used, the rationale is documented in the FDD report and the SPA references the agreed approach.
5. The exclusions list.
Several items routinely sit in current assets or current liabilities on the balance sheet but should be excluded from working capital for normalisation purposes:
- Cash and cash equivalents. Already separately treated in the cash-free, debt-free mechanism.
- Short-term borrowings. Part of net debt, not working capital.
- Current portion of long-term debt. Part of net debt.
- Dividend payable. Often treated as debt-like.
- Provision for income tax. Treated separately (either as debt-like or as a true-up item).
- Receivables / payables from related parties. Excluded if they are to be settled at closing, or included with adjustment to market terms.
- Restricted cash. Excluded from cash; usually excluded from working capital too.
- Customer advances above a threshold. Often treated as debt-like (the buyer must deliver against them).
The exclusions list is documented in the FDD and the SPA references the exact treatment of each.
6. Deal-doc drafting.
The SPA's working-capital clauses typically contain:
- The target. The agreed normalised working capital, in currency, as the reference point.
- The definition. What is included and excluded, line by line, by reference to specific GL accounts.
- The closing-statement procedure. Who prepares the closing working-capital statement, by when, using what data sources.
- The dispute resolution. The mechanism (typically an independent expert from a specified panel) for resolving disagreements.
- The true-up mechanism. How any difference between target and actual is settled in cash, by when.
The FDD's working-capital workbook becomes the working file for the closing-statement preparation. If the FDD and the closing statement are prepared on inconsistent definitions, the dispute resolution becomes expensive.
Frequently asked
Why 12 months and not 6 or 24?
12 months captures one full operating cycle (including seasonality) and reflects the current scale of the business. A 6-month average can over-weight a temporary period; a 24-month average can under-weight recent growth or contraction. Where the business has materially changed (acquisition, restructuring, divestment), the period is sometimes shortened to post-change months only.
What if the seller has been managing working capital tighter than normal in the months before sale?
This is window-dressing and is a common issue. The FDD compares the LTM monthly trend against the longer-term historical pattern. An unusual contraction of working capital in the 2 to 3 months before sale typically triggers an upward adjustment to the target, because the buyer should not be penalised for normal post-closing working-capital recovery.
How do GST and TDS payables fit in?
Both are typically included in working capital because they are recurring operating liabilities. Items with specific timing (e.g. annual TDS true-up, GST refund pending) may be treated separately.
Who prepares the closing working-capital statement?
Usually the seller, within an agreed number of days post-closing (typically 30 to 60 days), using the same definitions and methodology as the SPA target. The buyer reviews and either accepts or proposes adjustments. Disagreements go to the dispute-resolution mechanism.
Is the working-capital target ever set as a range rather than a point?
Some SPAs use a 'collar' - a range around the target where no adjustment is made, with true-up only outside the collar. The collar reduces disputes over small variances. The width of the collar is negotiated and depends on the materiality of working capital to the deal.
