Understanding Net Working Capital: What Every Buyer Needs to Know

When you're buying a business, you're buying its ability to operate on day one—and that means more than just revenue and profits. One of the most overlooked (and misunderstood) aspects of any acquisition is net working capital (NWC). It’s not flashy. It’s not headline-worthy. But if you get it wrong, it can quietly wreck your deal. Let’s break down what NWC is, why it matters, and how to handle it during the buying process.

Why Net Working Capital Matters

Imagine you close on a business and realize two weeks later that you need to inject $200,000 just to make payroll and buy inventory. That’s the kind of surprise NWC is designed to prevent. Net working capital represents the short-term operating liquidity of a business. In plain terms: it’s the money the business uses to fund its day-to-day operations. If the seller hands you a business without enough working capital to operate smoothly, you’ll need to come out of pocket—on top of what you already paid. That’s why most transactions include a “working capital peg”—a target amount of NWC that the seller agrees to leave in the business. The peg ensures that the buyer isn't immediately on the hook for operational shortfalls after closing.

How to Calculate Net Working Capital

The basic formula is straightforward:

Net Working Capital = Current Assets – Current Liabilities

But like most things in a deal, the nuance is in the details. You’re not just calculating a number; you’re trying to understand the normalized amount of NWC the business truly needs to operate. Here’s what’s usually included in NWC:

• Accounts receivable

• Inventory

• Prepaid expenses

• Accounts payable

• Accrued expenses (like salaries and wages)

And here’s what’s typically excluded:

• Cash

• Debt and debt-like items

• Investment accounts

• Unearned revenue

• Obsolete inventory or very old A/R

Adjustments: Normalizing the NWC

Not all NWC is created equal. To make the number meaningful, you’ll need to make a few types of adjustments:

1. Definitional Adjustments

These define what’s actually counted in the NWC. For example, you’ll usually exclude things like cash or loans—even if they technically show up in current assets or liabilities.

2. Due Diligence Adjustments

These account for non-operating or non-recurring items. If the business just took on a large one-off expense or wrote off a bunch of inventory, you’ll want to back those out.

This is also where you’ll spot accounting inconsistencies or unrecorded liabilities—both of which can have a big impact on NWC.

3. Pro Forma Adjustments

Let’s say the business recently changed payment terms with vendors, or started requiring customers to prepay. You’ll need to adjust the historical numbers to reflect how those changes will affect future working capital needs.

Setting the NWC Peg

The peg is your benchmark. It’s how much NWC the seller commits to leaving in the business at closing.

In most cases, buyers use a 12-month average of NWC to set the peg. But there are exceptions:

• Fast-growing businesses may require a shorter window (like 3–6 months) to reflect rising working capital needs.

• Seasonal businesses may require adjusting for periods of high or low activity.

The goal: make sure there’s enough NWC in the business to keep things running smoothly after the deal closes—without overpaying.

How NWC Is Handled in a Deal

The approach to NWC will vary depending on deal size and structure, but there are three common ways it’s handled:

1. Exclude NWC, Adjust the Price

In simpler, smaller deals, the buyer might provide their own working capital post-close. If the business needs $300K in working capital, the purchase price might be reduced by that amount.

2. Leave NWC in the Business

The seller agrees to leave current assets (like A/R and inventory) in the business. This can simplify negotiations—but make sure those assets are usable and accurately valued.

3. Post-Closing Adjustment (True-Up)

In larger or more sophisticated deals, the parties agree to estimate NWC at closing and finalize it later. If actual NWC is higher or lower than the estimate, a true-up adjusts the purchase price accordingly. This approach is rarely used in SBA-funded deals but is standard in private equity transactions.

The Role of a Quality of Earnings (QoE) Report

A solid QoE report will break down historical NWC, help set the peg, and identify any red flags like:

• Overstated receivables

• Understated liabilities

• Debt-like items that shouldn’t be included

If you’re buying a business of any meaningful size, a QoE is one of the best tools you have to understand working capital and avoid surprises.

Bottom Line

Getting net working capital right isn’t just about crunching numbers—it’s about de-risking your acquisition. Know what you’re buying. Make sure the business has what it needs to run. Avoid post-close surprises that eat into your returns.