The Importance of Considering Net Working Capital During Financial Due Diligence

When conducting financial due diligence for a potential business acquisition or investment, one crucial aspect that should not be overlooked is the evaluation of net working capital. Net Working Capital ‘NWC’ plays a vital role in understanding a ' company s short-term financial health and liquidity, as well as its ability to meet its operational and growth needs. This article aims to explore why ‘NWC’ should be a key consideration during financial due diligence and its implications for investors and acquirers.

Understanding Net Working Capital

‘NWC’ is calculated by subtracting a ' company s current liabilities from its current assets. Current assets include cash, accounts receivable, inventory, and other assets that are expected to be converted into cash within a year, while current liabilities encompass obligations that are due within the same period.

Essentially ‘NWC’ reflects the amount of capital available to cover a company ' s short-term operational expenses and its ability to fund growth opportunities without relying heavily on external sources of financing.

Importance During Financial Due Diligence

Assessing Short-Term Liquidity:

A thorough analysis of ‘NWC’ provides insights into a company’s ability to meet its short-term financial obligations, such as paying off suppliers, meeting payroll, and covering other operational expenses. A healthy level of ‘NWC’ ensures that a company can sustain its day- to-day operations without facing liquidity challenges.

Evaluating Working Capital Efficiency:

By examining the composition of a company’s working capital components, such as inventory turnover and accounts receivable turnover, potential investors and acquirers can gauge the efficiency of its working capital management. An excessive amount tied up in inventory or prolonged accounts receivable collection periods may signal operational inefficiencies and potential cash flow constraints.

Impact on Financing and Growth:

’NWC’ influences a company’s ability to fund its growth initiatives and capital expenditure without over reliance on external borrowing. A sufficient level of ‘NWC’ is indicative of a company’s self- sustainability and financial resilience, reducing the need for costly short-term financing arrangements.

Identifying Potential Risks and Opportunities:

An analysis of historical trends in ‘NWC’ can uncover patterns that may indicate underlying risks or opportunities. For instance, a consistent decline in ‘NWC’ may point to deteriorating financial health or aggressive working capital management, while a sudden increase may signify inefficient capital deployment or an impending need for additional investment.

Informed Decision Making

By considering ‘NWC’ during financial due diligence, investors and acquirers can make better-informed decisions regarding the financial soundness and potential risks associated with a target company. Furthermore, understanding the dynamics of ‘NWC’ can facilitate the formulation of proactive measures to optimize working capital management post-acquisition or investment, thereby unlocking value and improving the overall financial performance of the business.

In conclusion, ‘NWC’ is a fundamental element of financial due diligence that provides valuable insights into a company’s short-term financial position, operational efficiency, growth prospects, and risk factors. Its examination empowers investors and acquirers to make informed decisions and devise strategies to enhance the target company's financial health and performance. Therefore, considering ‘NWC’ should be an integral part of the due diligence process, contributing to a comprehensive evaluation of a target company ' s financial viability and potential.

How STEM Can Help

STEM Capital Advisors brings over 45 years of collective experience in M&A Advisory, actively contributing to more than 100 transactions across diverse industries. Our team ' s extensive knowledge and expertise uniquely position us to provide comprehensive support for financial due diligence in any sector. Emphasizing collaboration and excellence, we prioritize working closely with clients to develop customized solutions that address specific requirements, offering invaluable guidance and consultation at every stage of the deal process. Importantly, we maintain a close partnership with our clients, ensuring that our deliverables meet expectations and we all remain actively engaged throughout the entire process.