Understanding Working Capital and Its Impact on Business Value

Why a profitable business can run short of cash—and why working capital matters when selling a company.

Profitability and Cash Are Not the Same Thing

A company can report substantial profits and still struggle to pay its bills. The reason is often working capital: cash invested in inventory, receivables, and the operating cycle before customers pay.

Understanding working capital matters both when managing a business and when negotiating its sale.

What Is Working Capital?

In financial accounting, working capital is current assets minus current liabilities. In business acquisitions, buyers and sellers commonly negotiate a narrower measure called net operating working capital.

A simplified transaction measure is:

Net Operating Working Capital = Accounts Receivable + Inventory − Accounts Payable − Accrued Operating Expenses

Cash, income-tax balances, and interest-bearing debt are commonly excluded in cash-free, debt-free transactions. The actual components and accounting rules must be specified in the purchase agreement.

A Practical Example

Consider a manufacturing business with $300,000 in accounts receivable, $450,000 in inventory, $200,000 in accounts payable, and $50,000 in accrued operating expenses.

$300,000 + $450,000 − $200,000 − $50,000 = $500,000 of net operating working capital.

This is capital committed to keeping the business running—not necessarily cash available for the owner to withdraw.

Growth Can Consume Cash

Higher sales often require more inventory, additional payroll, and more receivables before the resulting revenue is collected. A profitable, growing company may therefore need additional financing.

Three useful measures are days sales outstanding (DSO), days inventory outstanding (DIO), and days payable outstanding (DPO). Together they produce an approximate cash conversion cycle:

Cash Conversion Cycle = DSO + DIO − DPO

For example, 45 days of receivables plus 60 days of inventory less 30 days of payables produces a 75-day cash conversion cycle. The company must finance that cycle.

From 'Price Plus Inventory' to Working Capital

For many years, especially in inventory-dependent businesses, it was common to negotiate a price for the business plus the inventory on hand at closing. Receivables were sometimes treated separately, too, because sellers viewed them as earnings already generated but not yet collected.

Those approaches were understandable, but they could obscure the economics of the overall deal. A buyer considering the total acquisition cost generally accounts for inventory and receivables whether they are included in the stated price or purchased separately.

There Is No Free Lunch

Suppose a business is offered for $2 million plus $400,000 of inventory and $300,000 of receivables. The total consideration is $2.7 million. An offer of $2.7 million including those same assets produces the same total consideration, assuming the same liabilities and other terms.

The labels differ; the economic cost to the buyer does not. Separate asset pricing is not automatically extra value for the seller.

The Working Capital Target

In many acquisitions, buyers and sellers negotiate a normal level of net operating working capital to be delivered at closing, often called the working capital target or peg. It may be based on historical monthly balances, with adjustments for growth, seasonality, obsolete inventory, and unusual items.

If the agreed target is $500,000, delivery of $575,000 might increase the purchase price by $75,000; delivery of $425,000 might reduce it by $75,000. This assumes a conventional dollar-for-dollar adjustment without special thresholds or exclusions.

The definition, measurement date, accounting policies, dispute process, and any post-closing true-up should be clear in the purchase agreement.

Giving the Buyer a Fair Start

A buyer taking over a business without adequate working capital may have to inject cash immediately to buy inventory, pay employees and suppliers, and bridge the period until customers pay.

That can jeopardize an otherwise sound acquisition. The seller also has an interest in the buyer's success, particularly when part of the purchase price is financed by the seller or depends on future results.

A business sold with insufficient operating working capital will generally be less attractive or command lower proceeds, all else equal. The adjustment may be exactly dollar for dollar under the contract; the effect on an initial offer can also reflect financing costs and risk.

The Buyer Must Receive the Business That Generated the Earnings

One principle I have emphasized in conversations with business owners over the years is straightforward:

The business being sold should include everything it currently relies upon to generate its existing earnings.

Working capital is only part of this principle. Sellers sometimes want to retain equipment for another venture, divert important customer relationships, or take other resources that helped generate the company's historical earnings.

If a manufacturer earns $600,000 in EBITDA using specialized equipment that the seller plans to retain, the buyer must replace that equipment or accept diminished capacity. Either consequence affects the transaction's economics.

Employees and customers are different from equipment: they cannot be guaranteed to remain after a sale. Their continuity depends on relationships, appropriate transition plans, contractual rights where applicable, and individual decisions.

A valuation based on the earnings of an intact operating company should contemplate the transfer or continued availability of the resources needed to sustain those earnings. If essential resources are excluded, the replacement cost, operating effect, and risk must be considered.

Improving Working Capital Before a Sale

Better collections, reasonable inventory levels, fewer obsolete items, and sound supplier terms can release cash and strengthen a company. But temporarily delaying payables or stripping inventory just before closing can damage operations and trigger a purchase-price adjustment.

The goal is efficient, sustainable working capital management—not a cosmetic balance sheet improvement.

The Bottom Line

Working capital is more than a balance sheet calculation. It is part of the operating foundation that allows a company to generate earnings.

The real question in a sale is not merely what price has been quoted, but what resources the buyer will receive at that price—and whether those resources will allow the business to continue successfully.

A buyer should receive a business capable of producing the earnings on which its valuation was based.

YourBizValue provides general educational information, not individualized financial, tax, legal, or valuation advice.