How Is Working Capital Dealt with When Selling a Construction Company?
There are a number of different factors that need to be taken into consideration and dealt with accordingly when it comes to selling a construction company. Some of these factors include valuating your business, getting all of your finances in order, preparing for the due diligence process, and so on.
Another important thing that needs to be considered before selling a construction company is how the company's working capital is to be dealt with during and after the sale.
Read ahead for a clear understanding of what working capital really is, how it is calculated, and why it is a relevant figure in the construction industry. After that, we'll go on to talk about how working capital is effectively dealt with in the sale of a construction company.
What is Working Capital, and How is it Calculated?
Effectively evaluating and managing working capital is a crucial aspect of running a construction company. In fact, working capital can oftentimes determine the success of any construction company. So, what is working capital? In the simplest of terms, working capital is the difference between the current assets and current liabilities of a company. The formula for working capital is as follows:
Working capital = current assets - current liabilities
In the case of working capital, the current assets are all of the cash or other assets a business owns that can be converted to cash within the duration of a one-year period.
Some examples of working capital include cash, inventory, raw materials, down payments for projects by customers, and any other assets a construction company owns that can be converted to cash in less than a year.
In the case of a construction company, the company’s biggest assets are usually the equipment they own, which is not considered a part of working capital since equipment cannot usually be converted to cash within a year.
The current liabilities are those liabilities and bills that are due to be paid off within a period of one year. This includes all credit card debts, other short-term business debts, all wages and salaries to be paid to employees and workers, as well as payments that need to be made to vendors for raw materials and supplies.
Working capital essentially measures a company's ability to make all of its due payments in the short term – as we mentioned, it is usually measured as a period within one year. By using the formula we mentioned before, a company can determine if it will have enough cash to pay off all of its bills and other dues. Additionally, only "current" assets and liabilities are considered because they are both short-term measures for a short-term period.
When it comes to actually understanding how effectively working capital contributes to a construction company’s bottom line, working capital turnover is considered. Working capital turnover shows you how working capital is used over a longer period of time and is measured as follows:
Working capital turnover = annual revenue / average working capital
Overall, the higher the working capital turnover ratio is, the better it is considered to be. For the average construction company, the working capital turnover should be between 3 to 7.
Within the construction industry, certain kinds of companies typically have the highest or lowest working capital turnover. For example, civil construction companies tend to have lower working capital turnover, whereas general construction companies have a higher working capital turnover.
Why Working Capital is A Relevant Figure in Construction and the Sale of a Construction Company
Working capital is an important figure in determining the success of any construction company, and as such, in determining whether a company might be successful once it has been sold as well.
Working capital is crucial for the day-to-day running of a company and helps evaluate things such as the liquidity of the company, how efficient the company is in its daily or short-term operations, and whether the financial health of the company is significant in the short term.
To get a better idea of why working capital is such an important factor in the success of a construction company, keep in mind that a typical construction company can be profitable but still end up insolvent – unable to pay off debts it owes – it if cannot manage to keep a steady flow of current assets to pay off all of its current liabilities.
Not only is working capital essential for the day-to-day running of the company, but it is also the metric that many banks and other financial institutions consider when deciding on whether they should lend the company any credit or bonds. So, working capital is a very important factor that comes into play in both keeping a construction company running as well as trying to grow the company.
Another thing to keep in mind is that there is an important distinction between working capital and cash flow. These two things are sometimes confused or used interchangeably but have very different meanings and applications.
Working capital is not simply cash flow as it also includes non-cash accounts like inventory that can be sold in a short time frame and payments that are due to be received shortly. Cash flow, on the other hand, comes largely from payments from clients. Given that the average DSO (day sales outstanding) for a construction company can go over the 60-day mark, cash flows are not enough to rely on to pay off urgent liabilities. This is why working capital is much more significant than simple cash flows.
Overall, it can be understood that the higher a construction company’s working capital is, the better that company’s financial situation is. In keeping with better financial health, it also follows that the company can function more efficiently in its day-to-day operations. This is important when it comes to company sales.
A company with higher working capital is likely to be valued at a higher selling price and have more buyers to choose from. However, there is one downside to having higher working capital and wanting to sell the company, and that is the question of how that working capital is going to be dealt with during and after the sale.
How Working Capital is Dealt with When Selling a Construction Company
When it comes time to sell a construction company, it is often very tricky for a seller and buyer to comfortably agree on a figure for working capital that both parties are satisfied with.
This is in part because the working capital is constantly changing from month to month and partly because it can be difficult to clearly define the different aspects of a company’s capital that are accounted into its working capital figure.
In order to get a fair deal from both the seller's and the buyer's perspectives, it is important for both parties to settle on a working capital amount that is acceptable to both the seller and the buyer.
To start off, when a company is being sold, both parties have to come to an agreement on a net working capital target – an NWC Target. This is the target net working capital that the seller agrees to deliver to the buyer when the company sale is closed. If there is any difference between the NWC target and the actual net working capital, then the seller is expected to reconcile the amount of the difference. This is usually done in the form of an adjustment to the agreed-upon purchase price of the construction company.
To come up with the NWC target, several factors are considered, and the historical average working capital of the company is considered, usually from the past two or so years. One of the factors kept in mind when determining the NWC target is company growth.
If the construction company is expected to grow rapidly, then it would need as much working capital as possible, and therefore, the target would be set keeping this growth in mind. The average of a shorter period during which the company is experiencing growth might be used to calculate the target.
Another factor considered when setting the NWC target is seasonality, which can play a huge role in the activity of a construction company. Many different kinds of construction companies have more work during the summer than they do in other seasons, meaning that depending on the time of year, business activity fluctuates greatly. This also means that a historical average might not make for the most accurate NWC target.
The NWC target does not always have to be a specific set number, a "peg," either, but it can be a range, too. It is up to the seller and the buyer to determine whether they want to settle for a peg or range and if they do settle for a range, then how big a range they want to go for. Additionally, a time period for the closing of the sale deal is also agreed upon by the seller and the buyer.
Finally, at the time of the closing of the sale, certain net working capital accounts might require some adjustments. One example that is particularly relevant to construction companies is that of inventories. Inventories should be assessed before a potential sale transaction to ensure that any old, obsolete, or defective inventory is not being reported in the company’s financial balances. Since inventory is likely only counted once a year or even less frequently, the shrinkage in the inventory can have an impact on the buyer’s assessment of the company during the closing of the sale. Similarly, other accounts like accounts receivable and payable might need to be adjusted during the time of closing the sale, which might then impact the net working capital.
The Bottom Line
Overall, it is important to understand that working capital is an important figure in determining the success of any construction company, and as such, in determining whether a company might be successful once it has been sold as well. In order to help sellers and buyers agree on how working capital will be dealt with when selling a company, many sellers and buyers include this as a part of the due diligence process.
With the help of business advisors or due diligence specialists, an NWC target peg amount or range can be settled on that both the seller and buyer are happy with. A time period for the closing of the deal can also be settled on, and in the best-case scenario, both parties are satisfied with the state of the construction company's working capital at the time of the closing of the sale.
N3 Business Advisors - Construction Industry Mergers & Acquisition Advisors
If you are looking for a team of experienced and professional business advisors to help you in the due diligence process or the sale of your construction company, N3 Business Advisors is the company to help you.
No matter what company goal you are hoping to achieve, be it dealing with working capital, achieving company growth, merging or acquiring, preparing your business for sale, valuating your construction company, carrying out due diligence, or meeting any other company goals, we have a qualified and diverse team that can help you out.
N3 Business Advisors has over 30 years of experience working with companies in the construction industry. Our team is made up of lawyers, due diligence experts, valuation experts, business advisors, accounts and financial advisers, and other professionals who can help you achieve your company's goals.
If you would like to set up a confidential consultation with N3 Business Advisors, visit our website, or call us at 647 967 4222. N3 Business Advisors is based in Ontario, and our office is at 55 Village Centre Place, Suite 200, Mississauga, ON L4Z 1V9.