Business sales that are concluded too quickly or without the proper considerations of an experienced team can have a lot of important factors to look at the last minute. Working capital is one such key factor that is often not considered significantly enough when a business sale is in process.
In this article, we want to take a look at what happens to inventory and working capital when selling a HVAC, Plumbing, Roofing, Distribution, Manufacturing or another business in the construction industry. To properly understand the influence of a business’s working capital on its sale price and eventual sale, we will first take a closer look at what working capital really is and how inventory plays a part in working capital. We will then look at how working capital is usually dealt with in a business sale or both smaller and larger businesses.
What is Working Capital?
Working capital is an effective measure of a business’s ability to be successful in the short run. It is essentially how much money is available for a business to be financially successful within a short period of time – usually the current year.
Working capital is calculated with a simple formula:
Working capital = current assets – current liabilities
The two main factors taken into account when calculating working capital are current assets and current liabilities.
Current assets include anything that is owned by the business that could be easily converted into cash in the short run – usually, this is considered to be one business cycle or one year. So, current assets are made up of cash, any amounts that are to be received in the year, inventory, and so on. All of these things can be quickly converted to cash within the timeframe of a year should the business be in need of finances in the short run.
Current liabilities are the expenses or debts a business has that need to be paid off in the short run – again, usually over one business cycle or year. This includes any accounts that need to be paid, such as property rent, utility bills, vendor payments, employee wages, taxes, interest payments on long-term loans, and so on.
As you can see from what makes up a business’s working capital, it becomes clear that working capital is a good measure to keep in mind when predicting the possible success of a business during the sale and right after the sale has been completed. Working capital can be a great measure to use when coming up with the business’s sale price, as well, and is often used in the valuation process. However, the problem arises when both parties involved in the sale of a business cannot agree on whether working capital should be included when calculating a business’s sale price or how much of the working capital should be considered.
Is Inventory Counted in Working Capital? And How Is It Included in a Business Valuation?
As we mentioned briefly already, inventory is definitely a part of working capital and is counted as a current asset. When it comes to what inventory really is, we can consider inventory to be made up of 3 essential parts:
- Items that the business holds to sell during their regular business workings
- Items that will be sold by the business in the short term
- Items that are used or consumed in the production process during a business’s regular workings
When we think about inventory for construction businesses, we can consider construction tools and consumable inventory like cement, screws, bolts, wire, and other supplies used in construction projects. Most construction businesses do not hold a lot of inventory for sale, like a retail business might, for example.
While inventory can be a huge part of valuable current assets for certain kinds of businesses, it is not always considered a very significant part of working capital for construction businesses. Most of a construction business’s valuable assets are long-term assets like equipment, plants, warehouses, and so on. Since these assets are not current assets, they are not considered a part of working capital.
Another important consideration is how inventory is included in a business valuation. In some instances, it makes sense to count inventory when calculating a business’s value for sale. This is usually if the inventory can be sold off and help the new business owner pay off any remaining business debts.
On the other hand, if the inventory held by a business is obsolete or cannot be sold, then it does not add much value to a business, and it would be preferred by the buyers if it was not calculated in the business’s valuation. Of course, a buyer in any business sale would want to keep in mind whether or not they would be able to buy a business, pay off any existing debts, earn a decent salary, and incur positive business growth. If all of this is done while still counting inventory in the business valuation calculations, then it will likely be counted.
When coming up with a closing deal, the buyer and the seller would need to agree not just on working capital as a whole and how it will be dealt with but also on how much inventory is to be included in the business valuation. In some cases, there might be more inventory than is needed to keep the business running. If that is the case, then the extra inventory would likely be sold before the sale is completed, with the seller keeping the amount received for it, or the seller would simply keep the extra inventory and do with it as they please once the business sale has been completed.
It is also important that both the buyer and the seller carry out a physical count of the inventory to know exactly what is owned by the business and how much of it is needed or should be sold off. Prior to closing the business deal, all of the inventory should be valued at a fair market price. In many instances, the buyer and seller would agree to hire a third party to value the inventory for them so that there is no bias in the valuation.
How Working Capital and Inventory is Typically Dealt with in a Business Sale
Now that we have a clearer idea of what working capital is and the role inventory plays in a business’s working capital, we can take a look at how businesses typically deal with working capital when it comes to a business sale.
Dictated by the size of the business being sold and the size of working capital, it is usually dealt with in one of two ways.
For smaller businesses, working capital is usually not a part of a business deal except for inventory. This means that the only inventory – out of all other current assets is considered. No current liabilities are kept in mind during the business sales. The buyer usually does not receive any of the cash or receivable accounts, and the seller gets to retain these amounts.
To get a better idea of what we mean by a smaller business, here are some of the parameters that dictate if working capital – other than inventory – will not be considered a part of the business sale:
- If the business was valued via the Seller’s Discretionary Earnings valuation method
- If the business owner and buyer are both single individuals
- If the business reports annual revenues lower than approximately $5 million
If the above conditions are true, then working capital is not a part of the business sale, and once the new buyer has bought the business, they would have to figure out working capital on their own, either through cash reserves or through loans from their lender.
For larger businesses and larger sale deals, the buyer likely expects that enough working capital will be sold along with the business so that the business can be operated for an agreed-upon timeframe following the sale. The working capital in such a case includes not just inventory but cash, accounts receivable, and more.
Here are some of the parameters that dictate if working capital – other than inventory – will be considered a part of the business sale:
- If the business was valued via the EBITDA valuation method
- If the buyer is an investment firm, a private equity firm, or any other kind of platform that is not limited to a single individual
- If the business reports annual revenues greater than approximately $5 million
If the above conditions are true, the buyer and seller will work together to come up with a target working capital to include in the sale price.
So, as we can see, working capital can be dealt with differently depending on the size of the business being sold, how significant a business’s working capital is, and the discretion of the buyer and the seller. The way that working capital is dealt with affects the value that the buyer gains from the sale and the way the business is valuated and the final sale price that is agreed upon.
The Bottom Line
In conclusion to the whole matter of working capital, it is important to know that working capital can play a big role in the final valuation of a business and can, therefore, greatly impact the sale price of a business. For many buyers, the working capital also represents whether or not a business can be successfully run immediately following the sale, as the working capital is used for day-to-day business deals in the short run.
Working capital should be calculated and included in the business valuation process by both the seller and the buyer in a business deal. If you are planning to buy or sell a business, it might be in your best interest to hire a professional business advisory team with business valuation experts. A business valuation expert would be able to advise you on exactly how you should approach working capital in a business sale transaction. At the time of closing the transaction, it would be ideal if both the seller and the buyer agreed on how to handle the business’s inventory and working capital.
N3 Business Advisors – Mergers & Acquisition Advisors for Construction Industry Businesses
Are you searching for a team of professional, industry specialist business advisors to help you in the business valuation process or the sale of your construction company? If you are, then be sure to get in touch with N3 Business Advisors.
Here at N3 Business Advisors, we can help you reach any business goal you set. Whether you are looking to effectively deal with working capital, merging or acquiring businesses, preparing your business for sale or growth, valuating your business, carrying out due diligence, or achieving other business goals, we are the company for you!
At N3 Business Advisors, we have a cumulative 30 years of experience. Our team of due diligence experts, valuation experts, lawyers, accounts and financial advisers, business advisors, and other professionals have all worked with various businesses in the construction industry and can help you achieve your business’s goals.
If you are interested in setting up a confidential consultation with us, give us a call at 647 967 4222 or visit our website. We are based in Ontario, and our office is located at 55 Village Centre Place, Suite 200, Mississauga, ON L4Z 1V9.