Financial Statement Analysis

Net Working Capital, Cash Conversion Cycle and the Peg

Net working capital is operating current assets minus operating current liabilities, typically receivables plus inventory less payables and accruals, excluding cash and debt. The cash conversion cycle measures how many days cash is tied up in operations. In acquisitions, a working capital peg sets the normal level delivered at closing, with price adjusted for any shortfall or excess.

What is net working capital in a transaction context?

Accounting texts often define working capital as current assets minus current liabilities. In transactions and credit analysis, the more useful measure is operating or trade working capital: the current assets and liabilities that arise from day-to-day operations. That usually means receivables, inventory, prepaid expenses, payables, accrued expenses and sometimes deferred revenue. Cash, short-term debt, current portions of long-term debt, income taxes and transaction-related items are excluded because they are financing or non-operating items handled separately in the purchase price. The definition used should match the purchase agreement exactly.

Working capital matters because it is a use of cash. A growing business must invest in more receivables and inventory, partially funded by suppliers through payables. That investment reduces free cash flow even when earnings rise. For lenders, working capital also forms the borrowing base for revolving facilities and represents collateral. For buyers, it is a component of what is purchased: a business needs a normal level of working capital to operate, and the purchase price assumes that level is delivered at closing rather than drained beforehand.

How is the cash conversion cycle calculated?

The cash conversion cycle measures the number of days between paying suppliers and collecting from customers. It combines three turnover measures. Days sales outstanding is how long customers take to pay. Days inventory outstanding is how long inventory sits before sale. Days payable outstanding is how long the company takes to pay suppliers. The cycle equals receivable days plus inventory days less payable days, and a shorter cycle means less cash is tied up in operations for each dollar of revenue.

Each component should be calculated on a consistent basis, using average or period-end balances against the corresponding annual flows: revenue for receivables and cost of goods sold for inventory and payables. Monthly trends reveal seasonality and period-end window dressing that annual figures can hide. A sudden improvement in days payable just before a sale, for example, may reflect stretched suppliers rather than an operational gain and is likely to reverse shortly after closing. Comparing each component with peers and with the company's own history helps distinguish structural features of the business model from temporary management actions, which matters when projecting how much cash the business will absorb as it grows.

What is a working capital peg and how is it set?

Most private acquisitions are priced on a cash-free, debt-free basis with a normal level of working capital. The peg, or target, is that normal level. At closing, the actual working capital delivered is compared with the peg. If it is lower, the purchase price falls dollar for dollar; if higher, the price rises, sometimes subject to a collar or a threshold. This mechanism prevents a seller from collecting receivables aggressively or delaying payables before closing to extract extra cash at the buyer's expense.

The peg is normally based on an average of monthly working capital over the trailing twelve months, which smooths seasonality. Adjustments are made for items excluded from the definition, for one-time anomalies such as a large customer prepayment, and for trends: if the business is growing quickly, a trailing average may understate the working capital needed at closing. Negotiations over the peg are common because each dollar moves the effective price by a dollar, making it one of the most direct value levers in a deal.

• Define accounts included and excluded consistently with the purchase agreement
• Use monthly balances over at least twelve months to capture seasonality
• Normalize for one-time items and accounting errors
• Consider growth trends and expected closing month seasonality

How do underwriters analyze working capital quality?

Beyond the totals, underwriters examine the quality of each component. Receivable agings show how much is current versus past due and whether reserves are adequate. Concentration in a few customers increases both credit risk and the effect of one slow payer. Inventory should be examined for slow-moving and obsolete items, with reserves tested against actual write-offs. Payables should be aged to detect stretched suppliers who may tighten terms after a change of ownership, which would absorb cash at the worst possible time.

For asset-based lenders, these details translate directly into availability. Ineligible receivables, such as those over a set number of days past due, from affiliates or from foreign customers, are excluded from the borrowing base. Inventory advance rates depend on liquidation values rather than cost. A business whose working capital looks ample on the balance sheet can have limited borrowing capacity if a large share of its assets are ineligible, and that gap needs to be understood before a revolver is sized.

What working capital issues cause disputes after closing?

Disputes typically arise from inconsistent accounting between the peg period and the closing balance sheet. If the peg was calculated with one approach to inventory reserves, accrued bonuses or revenue cutoff and the closing statement uses another, the adjustment can swing materially. Purchase agreements address this by specifying accounting principles, often consistent with historical practice, with a defined hierarchy of rules and an illustrative calculation attached as an exhibit that both sides agree to in advance. Small differences in judgment, applied to large balances, can create adjustments worth more than the reviewers expect at signing.

Other frequent issues include classification of items as working capital versus debt, such as customer deposits, deferred revenue and accrued taxes, and the treatment of items that change between signing and closing. Clear definitions, a sample calculation, and an independent accountant mechanism for resolving disagreements reduce the risk. Underwriters financing an acquisition should review the working capital mechanics because a large post-closing payment to the seller could strain liquidity in the early months of the loan. Escrows sized for working capital adjustments can also protect both sides from collection risk on any true-up.

Cash conversion cycle and peg adjustment

1. Annual revenue = $36.50 million; COGS = $25.55 million. Receivables $4.00 million, inventory $3.50 million, payables $2.10 million.
2. DSO = 4.00 / 36.50 x 365 = 40.0 days. DIO = 3.50 / 25.55 x 365 = 50.0 days. DPO = 2.10 / 25.55 x 365 = 30.0 days.
3. Cash conversion cycle = 40.0 + 50.0 - 30.0 = 60.0 days.
4. Net working capital = 4.00 + 3.50 - 2.10 = $5.40 million.
5. Peg set at the trailing twelve-month average of $5.00 million. Closing working capital delivered = $4.60 million.
6. Shortfall = 5.00 - 4.60 = $0.40 million, so the purchase price is reduced by $0.40 million.

How underwriters apply this

• Use monthly working capital data to set the peg and to detect pre-closing window dressing in payables or collections.
• Model working capital investment explicitly as revenue grows; ignoring it overstates free cash flow and debt capacity.
• Test receivable aging, inventory obsolescence and payable aging, not just totals.
• Reconcile working capital definitions with the debt and debt-like items schedule so nothing is counted twice or omitted.
• Plan liquidity for a potential post-closing true-up payment when financing an acquisition.

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