Glossary
Net Working Capital (NWC): Definition, Formula, and Why It Decides Deals
Net working capital is the money permanently trapped inside a business to keep it running. The textbook formula is current assets minus current liabilities. In a transaction that formula is almost never the right answer, and the gap between the textbook calculation and the negotiated one is regularly one of the largest unexpected numbers in a deal.
The useful way to think about it is this: what value is always going to be tied up in this business that I will never see as an owner? Receivables you are waiting on, inventory on the shelf, deposits you have paid and will not get back while you keep trading. As a business grows, that trapped number grows with it.
Why the standard calculation gets it wrong
Ask almost any accountant to calculate working capital and you can predict the result. They will take total current assets, subtract total current liabilities, and hand you the difference.
The problem is what sits inside those two totals on a small company balance sheet.
The current portion of debt is the most common distortion. Where an accountant has classified the current portion of loans within current liabilities, as they properly should for financial reporting, it reduces the working capital figure. That makes the number look smaller than the business’s real operating need.
Sellers are frequently surprised to learn this works against them. A seller who accepts their own accountant’s figure as the peg may be agreeing to leave behind a number that has been artificially deflated by debt that is being paid off at closing anyway.
Most deals are structured cash-free and debt-free, which means the buyer takes the business without its cash and without its debt. So before working capital is calculated at all, the balance sheet has to be stripped of everything that is not part of day-to-day operations: cash, all debt, lease liabilities, shareholder and related-party loans, income taxes and capital expenditure items.
Small company balance sheets are usually wrong
This is the part nobody warns sellers about, and it takes the most time in practice. The accounts are not just classified differently than we need. Many of them are not real.
We work through the general ledger account by account and remove or correct anything that is not a genuine operating balance. Some patterns recur constantly:
Inventory that never moves.
A balance that sits identical for months, jumps once, then sits identical again is not a valuation, it is a placeholder. We have replaced balances like that with a rebuilt estimate because the original could not be supported.
Adjustment accounts.
Ledgers routinely contain accounts literally named as adjustments, holding substantial balances somebody posted at some point and nobody revisited. They are not operating balances and they come out.
Allowances that were never calculated.
A round-number allowance for doubtful accounts with no supporting analysis behind it.
Related-party balances not at fair market value.
Which period to use, and why it matters more than the formula
Once the balance sheet is clean, the question becomes which historical period represents the normal working capital need.
Our default starting point is a trailing twelve month average. It is the right measure when a business has been stable, with comparable revenue and expenses year over year.
It is the wrong measure in two situations, and both are common:
Growth. A business whose working capital requirement has been climbing steeply will not be represented by a twelve month average, because most of those twelve months describe a smaller company. On one engagement the requirement had expanded substantially over three years and was still rising month over month, driven by receivables growing alongside earnings. A trailing twelve month figure would have understated what the buyer actually needed on day one, so we argued for a trailing three or six month measure instead.
Contraction. The mirror image. A declining business measured on a trailing twelve month basis will produce a peg above its current need, and the seller ends up leaving more than the business requires.
The trade that follows from this
There is a direct link between the earnings a seller wants credit for and the working capital they have to leave, and it is worth understanding before you negotiate.
Where a seller points to recent improved performance and asks for the price to reflect it, that is often reasonable. But recent performance is also the period in which working capital expanded. If the last six months are the true picture of the business for pricing, they are equally the true picture for the peg. A seller cannot use the recent run rate to lift the price and the older average to lower the working capital they leave behind.
We have made exactly that argument on a deal where the seller successfully reopened the purchase price on improving earnings. The price moved, and so did the peg, in the same direction and for the same reason.
Seasonality
Seasonal businesses need a normalized figure rather than a point-in-time one, and the effect can be extreme.
The clearest way to see it is a seasonal retailer. Buy a Halloween business on the twentieth of October and you are buying a warehouse full of inventory. Buy the same business on the tenth of November and there is almost none. The business has not changed. The date has. In the first case the buyer receives far more working capital than the business normally carries, and in the second, far less. The right peg is a blend that reflects the normal level across the cycle.
Most businesses are less dramatic and still meaningfully seasonal. Home services concentrate revenue in summer months. Builders in cold climates look materially different in December and January than in July and August. Any of those need a seasonally normalized peg rather than whatever the balance sheet happens to show at signing.
The adjustments we make most often
| Adjustment | Why |
|---|---|
| Reclassify debt out of current liabilities | Cash-free debt-free: it is being settled at closing and should not suppress the peg |
| Normalize prepaid expenses | Timing distortions in what has been paid ahead |
| Inventory reserves and obsolescence | Stock carried at cost that will not sell is not working capital |
| Remove related-party balances not at market | Not representative of arm’s length operations |
| Normalize one-time and non-recurring items | A single unusual month should not set the target |
| Accrual timing for under-accrued liabilities | Costs incurred but not yet recorded |
| Customer deposits and deferred revenue | Cash received for work not yet performed |
Deposits and deferred revenue, the genuinely contentious one
If your business takes money in advance, deal with this early, because it generates more argument than anything else in the working capital discussion.
The principle is that money received for work not yet performed is a liability rather than earned cash. The business owes that work. From a buyer’s point of view the most favourable treatment, and the defensible one, is that the full amount of customer deposits and deferred revenue stays with the business as cash at closing, because the seller has not earned it. The buyer will be performing the work it represents.
Sellers frequently see it the other way, having treated that cash as theirs for years. There are middle positions, and they get negotiated. What causes damage is discovering the issue late, after a price has been agreed on assumptions that no longer hold. See deferred revenue in acquisitions.
The same logic explains items sellers rarely think about. Lease security deposits across multiple locations can add to a substantial sum, and a buyer will never see that money while the business continues trading. It is only released if the business shuts down. Because it is permanently trapped, it belongs in the working capital the buyer receives.
Setting the peg, and the true-up
The negotiated target is the peg. At closing, actual working capital is measured against it, and the price adjusts for the difference: the seller is paid more if they leave more than the target, and less if they leave less. That adjustment is the true-up.
One rule prevents most post-close disputes: the true-up must use the same method as the peg. Where the peg is built one way and the closing calculation is run another, the two will differ for reasons that have nothing to do with how the business was run, and the resulting argument is unwinnable on both sides. Whatever method sets the target should be written down in enough detail that a different person could reproduce it. The working capital peg covers the mechanics.
On very small transactions a formal peg is sometimes more machinery than the deal warrants, and that is a legitimate call to make deliberately rather than by omission.
Frequently asked questions
What is the net working capital formula?
Current assets minus current liabilities. For a transaction, that starting figure is then adjusted: cash and debt removed, non-operating and incorrect accounts stripped out, and the result normalized over an appropriate period. The formula is the easy part.
How is net working capital different from the working capital peg?
Net working capital is what the business holds at a point in time. The peg is the negotiated target it is measured against at closing. The gap between them adjusts the price.
Why does my accountant’s working capital number differ from the buyer’s?
Usually because theirs is the reporting calculation and the buyer’s is the transaction calculation. The most common single cause is the current portion of debt sitting in current liabilities, which suppresses the figure. Balance sheet accounts that are not real operating balances account for much of the rest.
Should the peg be a trailing twelve month average?
It is the right default for a stable business. If yours is growing or shrinking meaningfully, a shorter period usually represents the real need better, and that is worth raising rather than accepting a default that does not fit.
We take customer deposits. What should we expect?
Expect it to be the most negotiated item in your deal. Buyers will argue the cash should stay with the business because the work is unperformed. Model the outcome under both treatments before you agree a price, so you know what you are actually accepting.
Can working capital change the purchase price after closing?
Yes, that is precisely what the true-up does. It is a normal mechanism rather than a renegotiation, and it is usually settled within a few months of closing.
Where to next
Working capital is the part of a deal most often agreed in principle and argued about in detail, and almost all of that argument is avoidable with a clean balance sheet and a method both sides wrote down. If you are preparing to sell, the highest-value preparation is removing accounts that are not real and being able to explain your seasonality. Our transaction advisory services team sets the peg on every engagement. Read the working capital peg for the mechanics and inventory in due diligence for the component that moves it most. To talk through a specific deal, email Avnit Sekhon at avnit.sekhon@treewalk.com.
