How Much Working Capital Do You Need When Buying a Business?
Buying a business has many complexities. Understanding the business value, negotiating with the seller, obtaining finance, conducting due diligence, working with attorneys, accountants, tax advisors, government agencies and more.
With so many areas to review, negotiate and decide, there is one area that is easy to forget. This is the amount the buyer needs to manage working capital to operate the business. The reason a buyer can forget is that the seller generally will not thinking about it. The sellers concerns are selling their business and their future plans. They have little concern about the future success of the business as this is the decision for the buyer.
What is working capital?
Working Capital, at its simplest, is the amount of money the business needs to run on a day to day basis to cover its costs so it remains operational to build long term surplus profit.
How much does the buyer need?
There is no one size fits all to the amount of working capital the buyer needs. A better question would be: “How much does the buyer need when they take over the ownership and operation of the business?”
The reason this is a better question is because the buyer needs to consider the following to arrive at the right amount of working capital they need to own and operate their business.
- How is the business currently performing? Is it growing quickly or declining quickly or nice and steady? Working capital needs are more unpredictable for a fast growing or fast declining business. A business that is steady has a more predictable amount of working capital.
- Does the business make one off unpredictable large expenditures?
- Is the business seasonal, that is, does its performance change markedly throughout the year? If so, does the amount of working capital fluctuate with the demands of the season?
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How does the buyer determine the right amount?
It is far better for the buyer to have too much than not enough. Not enough working capital can lead to closing the business. Not enough is also not good as it means money is not being deployed properly by attracting a reasonable rate of return. For a buyer to determine the right amount of working capital consider the following.
- Ask the seller for their recommendation. If the seller provides a recommendation, ask them to explain the number so you can check and make sure it’s accurate.
- Ask your accountant or CPA to help make that calculation.
- Other sources of information include checking with the trade association of the industry the business is in. As them if they can suggest what is normal for the industry. Ratios may be available such as working capital as a percentage of sales.
- The amount of working capital should be a calculation from the financial statements; just make sure the financial statements are accurate.
Working capital for your business in your industry
It is so easy to forget or miscalculate the amount of working capital especially when you are buying a business and have so many other items to address.
It’s critical to research and understand the working capital for your specific business in your specific industry. This means making the calculations not only for the first few months from when you take over the ownership of the business but also for the full year. For example, some retail businesses have the majority of their sales for the year in the 10 weeks lead into Christmas. If the buyer takes over in February and cruises to August and thinks the business is in good shape they may need to buy a lot of inventory for Christmas items but lack the necessary amount of working capital.
Working Capital has no room for error when buying a business. Get it right and the business has a chance at success. Also remember, the need for working capital never stays static and constantly changes.
For more immediate help with buying a business you are welcome to send an email to Andrew Rogerson or give me a call on 916 570-2674.