Key Takeaways
- Working capital in an M&A transaction is generally based on defined operating current assets and liabilities, but the purchase agreement determines exactly what is included and excluded.
- Buyers and sellers commonly establish a working capital target, or “peg,” representing the normalized level of working capital expected to remain in the business at closing.
- If closing working capital differs from the agreed target, the purchase price may be adjusted according to the transaction documents.
- Buyers should analyze seasonality, growth, receivables, inventory, payables, accounting practices, and other operating trends before agreeing to a working capital methodology.
Working capital can have a direct impact on the economics of an acquisition, yet it is sometimes treated as a secondary issue until relatively late in the transaction process.
For buyers, that can be a mistake.
An acquisition price is typically based on the assumption that the buyer will receive an operating business capable of continuing normal operations after closing. If the company arrives with significantly less working capital than expected, the buyer may need to inject additional cash immediately after taking ownership.
Working capital adjustments are designed, in part, to prevent that outcome.
Understanding the working capital definition, target, calculation methodology, and post-closing true-up is therefore an important part of buy-side financial diligence and transaction structuring.
What Is Working Capital in an M&A Deal?
At its simplest, accounting working capital is calculated as:
Current Assets – Current Liabilities = Working Capital
In an M&A transaction, however, the calculation is often more specific.
Rather than automatically including every balance sheet account classified as current, the parties generally negotiate which operating assets and liabilities will be included in the transaction’s definition of net working capital.
Depending on the business and agreement, working capital may include items such as:
- Accounts receivable
- Inventory
- Certain prepaid expenses
- Accounts payable
- Accrued operating expenses
- Other defined operating current assets and liabilities
Cash, debt, transaction expenses, income taxes, and certain other balances may be excluded or addressed elsewhere in the purchase price calculation.
The precise treatment depends on the transaction documents.
Why M&A Working Capital Is Different From Balance Sheet Working Capital
A buyer should not assume that the total current assets and current liabilities shown on a company’s balance sheet automatically equal M&A working capital.
The purchase agreement should establish the applicable definition and methodology.
That may include:
- Which accounts are included
- Which accounts are excluded
- How reserves are calculated
- Which accounting principles apply
- Whether historical accounting practices should be followed
- How unusual items are treated
- How post-closing disagreements are resolved
Those details matter because seemingly small definitional differences can create meaningful changes in the final purchase price.
Why Does Working Capital Matter to an M&A Buyer?
A buyer is generally acquiring an operating business, not simply a set of assets and liabilities frozen at a particular moment.
The company still needs to pay employees, purchase inventory, collect customer receivables, pay suppliers, and fund ordinary operations immediately after closing.
If the seller materially reduces normal working capital before the transaction closes, the buyer may inherit those operating obligations without the resources expected to support them.
For example, a seller might accelerate customer collections while delaying vendor payments. That could increase cash available to the seller before closing while leaving the acquired company with unusually low receivables and unusually high payables.
A properly constructed working capital mechanism is intended to help account for these changes.
Buyers Are Acquiring an Operating Business
The central concept is straightforward:
The buyer generally expects the company to be delivered with a normalized level of operating working capital.
The purchase price is usually negotiated based on assumptions about a functioning business. The working capital adjustment helps determine whether the business delivered at closing is economically consistent with those assumptions.
What Is a Working Capital Peg in M&A?
The working capital peg, also called target working capital, is the agreed level of working capital the business is expected to deliver at closing.
The target is generally intended to represent a normalized amount of working capital required to operate the company under the assumptions supporting the transaction.
If actual working capital at closing is different from the peg, the purchase price may be adjusted.
How Is a Working Capital Peg Determined?
A common starting point is historical monthly working capital.
However, simply averaging the last 12 months is not necessarily appropriate for every company.
Buyers should consider:
- Historical monthly balances
- Seasonality
- Revenue growth or decline
- Changes in customer payment patterns
- Vendor payment terms
- Inventory requirements
- New business lines
- Acquisitions or divestitures
- Unusual balances
- Nonrecurring operating events
The objective should be to determine a reasonable normalized level—not to select whichever calculation produces the most favorable result for one side.
How Does a Working Capital Adjustment Affect the Purchase Price?
The working capital adjustment generally compares the company’s working capital at closing with the agreed target.
Consider a simplified example.
Assume:
Working capital peg: $2 million
Closing working capital: $1.7 million
The business was delivered with a $300,000 shortfall relative to the target.
If the agreement provides for a dollar-for-dollar adjustment, the purchase price would generally be reduced by $300,000.
Now consider the opposite situation:
Working capital peg: $2 million
Closing working capital: $2.2 million
The company was delivered with $200,000 more working capital than required by the target. Under a two-way dollar-for-dollar adjustment, that could result in an additional $200,000 being paid to the seller.
Actual mechanics depend on the definitive agreement.
What Goes Into Net Working Capital in an M&A Transaction?
The quality of individual working capital accounts can be just as important as their reported balance.
Accounts Receivable
A buyer should evaluate whether reported receivables are likely to be collected.
Important considerations include:
- Aging
- Past-due balances
- Customer disputes
- Concentration
- Historical write-offs
- Allowance for doubtful accounts
- Changes in collection patterns
A $1 million receivable balance does not necessarily represent $1 million of economically realizable working capital if significant amounts are unlikely to be collected.
Inventory
Inventory can also require detailed analysis.
Buyers should consider:
- Obsolete inventory
- Slow-moving items
- Inventory reserves
- Seasonal inventory requirements
- Excess stock
- Historical write-offs
- Changes in purchasing patterns
A large reported inventory balance may overstate economic value if a meaningful portion cannot be sold in the ordinary course.
Accounts Payable
Accounts payable deserve particular attention because payment timing can materially change closing working capital.
If a company normally pays vendors within 30 days but begins stretching payments to 60 or 90 days before closing, reported cash may improve while liabilities accumulate.
A buyer should determine whether payable balances and payment practices are consistent with normal operations.
Accrued Expenses
Accrued payroll, bonuses, operating costs, and other expenses may also be included in working capital depending on the agreement.
The important issue is consistent treatment.
A liability should not disappear from the transaction economics simply because it was historically recorded differently or omitted from interim financial statements.
What Is Usually Excluded From M&A Working Capital?
Although treatment varies, certain balances are often addressed separately rather than through the working capital calculation.
Potential examples include:
- Cash and cash equivalents
- Interest-bearing debt
- Accrued interest
- Certain taxes
- Transaction expenses
- Certain debt-like liabilities
The transaction documents should clearly establish the treatment of these items.
Working Capital vs. Debt-Like Items
One of the more difficult areas in M&A is determining whether a liability belongs in working capital or should instead be treated as debt-like.
Potential areas of discussion can include:
- Accrued bonuses
- Deferred revenue
- Customer deposits
- Unpaid capital expenditures
- Transaction-related liabilities
- Change-in-control payments
- Certain aged payables
There is no universal answer for every item.
Buyers should evaluate the economic substance of the obligation and make sure that an item is not counted twice—or omitted entirely—from the transaction economics.
Why Seasonality Can Change the Working Capital Peg
Seasonal businesses require additional analysis.
Consider a company that builds inventory during the summer in preparation for its strongest sales period in the fourth quarter.
If the transaction closes immediately before peak season, the company may require substantially more inventory and working capital than its annual average suggests.
Using a simple trailing average without understanding the operating cycle could therefore produce an inappropriate target.
Example of a Seasonal Business
Suppose normalized working capital averages $2 million throughout the year but regularly reaches $3 million immediately before peak season.
If the buyer closes just before that period and receives only $2 million of working capital, it may need to contribute an additional $1 million soon after closing simply to operate the company normally.
Historical averages should therefore be considered in context.
Growth Can Also Distort Historical Working Capital
Rapid growth can create a similar problem.
A growing company may need more inventory, larger receivable balances, additional payroll, and increased operating resources.
If revenue has increased substantially during the most recent year, an average based heavily on older periods may understate the working capital required after closing.
The reverse can also occur in a declining business.
Buyers should determine whether historical working capital is representative of the business they are actually acquiring.
Estimated Working Capital at Closing vs. the Post-Closing True-Up
Final balance sheet information may not be available on the day the transaction closes.
For that reason, many transactions use an estimated working capital amount at closing.
A typical process may involve:
- Estimating closing working capital before closing.
- Using that estimate to calculate the initial purchase price.
- Preparing a final closing balance sheet afterward.
- Comparing final working capital with the estimate and agreed peg.
- Making a final payment or adjustment where required.
What Is a Working Capital True-Up?
A working capital true-up is the post-closing reconciliation between estimated closing working capital and the final working capital amount determined under the methodology established in the purchase agreement.
The true-up can result in an additional payment from the buyer or a repayment by the seller, depending on the calculation.
Accounting Methodology Can Be as Important as the Peg
Agreeing on a working capital target is not enough.
Two parties could agree that the correct peg is $2 million but still reach very different closing calculations if they apply different accounting methods.
The transaction documents should therefore address how working capital will be calculated.
Relevant issues may include:
- Applicable accounting principles
- Historical accounting practices
- Consistency requirements
- Reserve methodologies
- Account classifications
- Cutoff procedures
- Estimates
- Specific agreed adjustments
Consistency Matters
Suppose the seller historically calculated its allowance for doubtful accounts using one method.
If the buyer uses a significantly more conservative methodology when calculating final closing working capital, the resulting adjustment could become disputed even though nothing changed economically in the underlying receivables.
Clear methodology helps reduce that risk.
Common Working Capital Issues Buyers Should Watch For
During diligence, buyers should pay attention to unusual changes in working capital behavior.
Potential warning signs include:
- Accelerated receivable collections
- Delayed vendor payments
- Reduced inventory purchases
- Significant overdue receivables
- Changes in reserves
- Unusual inventory buildup
- Inventory depletion
- Large accrued liabilities
- Changes in payment terms
- Significant recent growth or contraction
The Goal Is Normalized Working Capital—not Maximum Working Capital
Buyers should not approach the working capital peg as an opportunity to extract as much value as possible.
The objective is to receive a normalized level of working capital consistent with the business and valuation assumptions.
An unrealistically high peg can create unnecessary friction just as an insufficient peg can leave the buyer undercapitalized after closing.
Working Capital Adjustment vs. Retrading the Deal
A working capital adjustment should generally be distinguished from retrading.
If the parties agreed that the purchase price would change based on closing working capital relative to an established target, applying that formula is part of the negotiated transaction mechanics.
A retrade generally involves reopening previously proposed economics because of new information, changed circumstances, or another issue.
The distinction matters because a properly applied working capital adjustment is not simply a buyer deciding to lower its offer.
Why Buyers Should Analyze Working Capital Before Signing the Purchase Agreement
Working capital should be analyzed during financial diligence—not after the purchase agreement is substantially negotiated.
Analyze Monthly Data—not Just Year-End Balance Sheets
Monthly information can reveal patterns that annual financial statements may hide.
Buyers can use monthly data to evaluate:
- Seasonality
- Receivable trends
- Inventory cycles
- Vendor payment practices
- Cash conversion
- Month-end fluctuations
- Growth-related changes
Understand the Normal Operating Cycle
Buyers should understand how capital moves through the business:
Inventory → Sales → Accounts Receivable → Cash
At the same time, they should understand how accounts payable and other operating liabilities finance part of that cycle.
The working capital peg should reflect the economics of how the company actually operates.
How Buyers Can Reduce Working Capital Disputes
Many working capital disputes originate from ambiguity rather than fundamental disagreement.
Buyers can reduce that risk by addressing important details before closing.
That includes:
- Clearly defining included accounts
- Clearly defining excluded accounts
- Agreeing on accounting methodology
- Establishing the peg based on appropriate analysis
- Addressing unusual balances
- Defining estimated closing procedures
- Establishing the post-closing true-up process
- Providing review periods
- Establishing a dispute-resolution mechanism
Financial diligence professionals, M&A advisors, accountants, and legal counsel should coordinate so that the commercial agreement and contractual language reflect the same methodology.
How a Buy-Side M&A Advisor Helps Evaluate Working Capital
Working capital affects valuation, purchase price mechanics, financing needs, and post-closing liquidity.
A buy-side M&A advisor can help an acquirer analyze historical working capital, identify unusual trends, assess normalized requirements, and understand how the proposed peg affects overall transaction economics.
That may include:
- Reviewing historical working capital
- Evaluating seasonality
- Assessing growth-related requirements
- Identifying unusual balances
- Reviewing the proposed peg
- Coordinating with financial diligence providers
- Evaluating purchase price implications
- Assessing the effect on post-closing liquidity
- Identifying issues requiring additional diligence
At PHG Advisory, working capital is considered within the broader acquisition framework of valuation, diligence, transaction structure, and deal economics.
Legal counsel should draft and advise on the definitive working capital provisions, while financial and M&A professionals help ensure that the underlying economic assumptions are understood.
Working Capital Can Change the Economics of an M&A Deal
The headline purchase price does not tell a buyer everything about the economics of an acquisition.
Working capital determines, in part, whether the buyer receives a business with the operating resources expected at closing.
A disciplined buyer should understand what constitutes working capital, what normalized level the business requires, how the peg was developed, how closing balances will be calculated, and how the post-closing true-up will work.
Those questions become particularly important when the company is seasonal, growing rapidly, experiencing changes in payment practices, or carrying unusual balance sheet items.
Working capital should therefore be analyzed as part of the broader acquisition strategy—not treated as a closing-day accounting exercise.
For buyers, thoughtful working capital analysis can help protect transaction economics, reduce unexpected post-closing funding requirements, and support more disciplined M&A execution.
Frequently Asked Questions
What is working capital in an M&A transaction?
Working capital in M&A generally refers to defined operating current assets minus defined operating current liabilities. The exact accounts included and excluded are established in the acquisition agreement.
What is a working capital peg in M&A?
A working capital peg is the negotiated target level of working capital the business is expected to deliver at closing. It is generally intended to represent a normalized level required to operate the company.
How does working capital affect the purchase price?
Closing working capital is often compared with the agreed peg. Depending on the purchase agreement, working capital above the target may increase purchase consideration, while working capital below the target may decrease it.
What is a working capital true-up?
A working capital true-up is the post-closing reconciliation between the estimated working capital used at closing and the final working capital amount calculated afterward using the agreed methodology.
Why should an M&A buyer analyze working capital before closing?
Inadequate working capital can require the buyer to inject additional cash immediately after acquiring the business. Careful analysis also helps ensure that the purchase price adjustment mechanism reflects the company’s actual operating needs.
