casemark/conducting-working-capital-due-diligence

Conducting Working Capital Due Diligence

When To Use

• Buyer or seller side in an M&A transaction needs to establish a working capital peg for the purchase agreement
• Evaluating whether a target's reported working capital reflects normalized, sustainable operating levels
• Structuring the post-closing true-up mechanism (adjustment collar, escrow, dispute resolution)
• Assessing seasonal or cyclical distortions in current assets/liabilities before signing

Inputs To Gather

• Trial balance and general ledger detail for the trailing 12–24 months (monthly granularity)
• Balance sheet at each month-end for the reference period, with sub-account breakouts for receivables, inventory, payables, accrued liabilities, and prepaid expenses
• Revenue and COGS schedules to correlate WC swings with business activity
• Accounts receivable aging reports and bad debt reserve history
• Inventory valuation methodology (FIFO, LIFO, weighted average) and obsolescence/slow-moving reserve schedules
• Accounts payable aging and any stretched-payment or early-pay discount programs
• Accrued liabilities detail — bonus accruals, warranty reserves, customer deposits, deferred revenue
• Intercompany balances and management fee allocations
• Draft or executed purchase agreement — specifically the WC definitions, excluded items, and adjustment mechanics sections
• Quality of earnings (QoE) report, if available, for cross-reference on normalizing adjustments

Workflow

1. Define the Working Capital Framework

• Identify which balance sheet line items are included/excluded per the purchase agreement definition (e.g., cash and debt are almost always excluded; tax assets/liabilities may be carved out)
• Confirm whether the definition uses net working capital (current assets minus current liabilities) or a customized subset
• Map each GL account to an included or excluded category; flag ambiguous accounts for negotiation [VERIFY against draft SPA language]

2. Build the Monthly Bridge

• Populate a 12–24 month monthly working capital schedule using the defined components
• Calculate month-end NWC for each period; compute the trailing 12-month average, median, and identify outlier months
• Chart NWC alongside revenue to visualize seasonality and operating leverage effects

3. Normalize Working Capital

Apply adjustments for items that distort run-rate WC levels:

• Non-recurring items — one-time inventory write-downs, litigation accruals, restructuring reserves
• Timing distortions — quarter-end channel stuffing, delayed vendor payments, accelerated collections before close
• Policy changes — shifts in revenue recognition, changes to reserve methodology mid-period
• Related-party / intercompany items — management fees, shared-services allocations that will not continue post-close
• Transaction-related accruals — deal bonuses, advisor fees, change-of-control payments

Document each adjustment with a clear rationale and dollar impact. Mark any adjustment relying on management representations with [VERIFY].

4. Calculate the Working Capital Peg

• Compute the normalized average (typically trailing 12 months) after all adjustments
• Sensitivity-test the peg by excluding high/low months or using a shorter reference period
• Compare the peg to the estimated closing date balance sheet to quantify the expected true-up direction and magnitude
• If the target has strong seasonality, consider whether a fixed peg or a seasonally adjusted peg is more appropriate [VERIFY with deal team preference]

5. Structure the Adjustment Mechanism

• Collar / de minimis threshold — recommend a collar (e.g., +/- $X around the peg) within which no adjustment is made; size the collar relative to NWC volatility
• Escrow / holdback — estimate the appropriate escrow amount based on the magnitude of potential shortfall
• Dispute resolution — confirm the SPA specifies an independent accounting firm, timeline for objection notices (typically 30–60 days post-closing), and which accounting standards govern the closing balance sheet
• Permitted leakage — in locked-box deals, identify permitted leakage categories and verify they do not erode the WC position

6. Identify Risk Areas and Open Items

• Flag accounts with high subjectivity (e.g., warranty reserves, percentage-of-completion accruals, inventory obsolescence)
• Note any data gaps — missing months, unreconciled intercompany balances, lack of sub-ledger detail
• Highlight management estimates that could swing the peg by more than 5%

Output

• Working Capital Summary Table — monthly NWC for the reference period, with each normalizing adjustment shown as a separate line, arriving at the normalized peg
• Peg Recommendation — stated dollar amount with sensitivity range and rationale for the reference period chosen
• Adjustment Narrative — description of each normalization adjustment, dollar impact, and supporting evidence
• Risk and Open Items Log — list of unresolved data issues, subjective estimates, and items requiring further negotiation
• Mechanism Recommendations — proposed collar size, escrow amount, and key SPA provisions to negotiate

Quality Checks

• Normalized NWC peg reconciles back to the unadjusted monthly schedule (adjustments net correctly)
• No double-counting between WC adjustments and net debt / transaction expense adjustments in the purchase price bridge
• Peg reference period is consistent with the period used in the QoE report (if one exists)
• Each normalization adjustment has a documented source (GL entry, management memo, or third-party confirmation)
• Seasonal patterns are acknowledged — if the closing date falls in a peak/trough month, the estimated closing NWC reflects that reality
• SPA WC definition and the analysis framework use identical account inclusion/exclusion [VERIFY SPA exhibit against model mapping]