In every acquisition that we have put together, there is one common question that the sellers ask as the deal moves toward closing: How much cash will I be required to leave in the business?
Obviously, owners don’t want to leave “too much” in cash or cash equivalents in the coffers. At the same time, there is a natural tension from the acquirer, who wants to ensure he has enough cash to run the business.
As an M&A firm, we’ve been lucky. All of the clients we have worked with have had more cash or cash equivalents than they really needed to meet all the cash demands of ongoing operations. They kept these strong positive balances for a number of reasons. Mostly, the cash reserve has been maintained for peace of mind, but also to have liquidity to take advantage of early-pay discounts or buying opportunities.
From the perspective of the buyer who is trying to acquire a business from one of our clients, the buyer would certainly like to inherit a big fat balance of cash or cash equivalents. Yet you, the seller, do not need to leave over-large balances to be assumed by new ownership. Accordingly, there is a balance to be struck between buyer and seller.
But what’s fair? What figure or formula can be used that is acceptable to all and won’t start a battle or create a sticking point as you move toward closing the deal? Luckily, there is a tried-and-true formula for calculating an acceptable cash or cash equivalent balance to be left in place for the new owner. This “working capital ratio” is widely used, and at 1st West Merger and Acquisitions, we have never seen meaningful pushback on it, as long as there weren’t extraordinary liabilities to cover that are the seller’s responsibility.
The typical acceptable working capital ratio is 1.5 to 1. In other words, when you sell your business, you should leave $1.50 in current assets on hand for every $1 in current liability. Before handing over your business, anything over that amount can be withdrawn by you, the owner, without raising protests from the acquirer. Here’s an example of how to categorically calculate that figure: Your current assets are typically represented by three categories:
1. Cash on hand
2. Accounts receivable
Your current liabilities are typically accounts payable and other payable liabilities, including pre-pays for items you have not yet delivered.
Let’s plug in some numbers and calculate an actual ratio, using round numbers for ease of math. Assume you have the following current assets:
• Cash: $1,500,000
• Accounts receivable: $300,000
• Inventory: $500,000
Your total current assets are $2,300,000. (ProTip: When calculating the AR figure, be sure to account for any bad debt that you might experience. If you historically collect 96% of your AR, don’t make an assumption of 100% when calculating the working capital ratio. You would likely be called out on that by the acquirer and asked to correct it.) Now let’s look at current liabilities. Assume you have the follow current liabilities:
• Accounts Payable: $500,000
• Other: $50,000
Your total current liabilities are $550,000. Now let’s express that as a ratio by dividing the current assets by the current liabilities. The formula would look like this: $2,300,000 / $550,000 = 4.8 to 1. In this case, a business owner with $2,300,000 in current assets and $550,000 in current liabilities has a 4.8:1 working capital ratio (WCR), far more than what an acquirer can reasonably expect to be left in the business upon an acquisition.
Accordingly, since current assets exceed liabilities, you (the seller) can work your current assets down, typically by extracting cash, or possibly by reducing inventory. You would take enough out so that you achieve a 1.5 to 1 ratio.
In this case, we would advise the owner who is selling the business to work current assets down to $825,000. (We achieved that $825,000 figure by simply multiplying the liabilities by 1.5. The formula looks like this: $550,000 x 1.5 = $825,000.) That ratio works very much in favor of the owner who is selling. He can work his current assets of $2,300,000 down to $825,000 by extracting $1,475,000 for himself or the seller will have to come up with that figure upon close.
Will an acquirer scream and shout when he realizes that you are taking cash out of the business ahead of a sale? Not if you make the case for a reasonable working capital ratio, and use the industry standard 1.5:1 number in your calculation.