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Understanding Net Cash/(Debt) and Net Working Capital in M&A

In mergers and acquisitions (M&A), Net Cash/(Debt) and Net Working Capital (NWC) are critical metrics for assessing a company's liquidity, operational efficiency, and value. Proper calculation and interpretation are vital to avoid valuation discrepancies, particularly during the drafting of the Sale & Purchase Agreement, including the calculation of Completion Mechanics (link to article). This article explains these metrics, their calculation, and their role in linking Enterprise Value (EV) to Equity Value (EQV), with an example at the end.

What is Net Cash/(Debt)?

Net Cash/(Debt) measures a company's financial leverage, highlighting the balance between liquid resources and third party debt and debt-like obligations.

Defining Cash, Cash-Like, Debt, and Debt-Like Items

Cash and Cash-Like Items

Cash refers to the actual liquid funds a company holds, including physical cash and deposits available on demand, such as:

  • Cash on hand: Physical currency or coins held by the company
  • Cash equivalents: Short-term, highly liquid investments (such as Treasury bills or short-term deposits) that are readily convertible into known amounts and have insignificant risk of changes in value
  • Marketable securities: Investments in financial instruments that are easily tradable in the market and can be quickly converted into cash

Cash-Like Items are those assets that are almost as liquid as cash, often used interchangeably in financial analysis:

  • Short-term investments: Typically, financial instruments that can be liquidated within 3 to 12 months, with minimal market risk
  • Supplier deposits or overpayments: Payments made in advance to suppliers or creditors, ahead of those falling due within the period
  • Tax assets: Recoverable tax claims as yet unprocessed (or received) but for which certainty exists that an obligation from HMRC exists, what the value of that is and the timeframe it falls due is within control

Debt and Debt-Like Items

Debt refers to any third party liabilities that a company owes, including:

  • Bank loans & overdrafts: Borrowed funds from financial institutions, typically with fixed or variable interest rates
  • Bonds and debentures: Long-term debt securities issued by the company to raise fixed capital
  • Lease liabilities: Obligations arising from the lease of assets (under IFRS 16 or similar standards)
  • Factored Assets: Short-term borrowings, where the rights to cash arising from owned assets are pledged or sold to financial intermediaries and which require repayment

Debt-Like Items are obligations that are not classified as third-party-debt but still represent liabilities that must be settled:

  • Corporation Tax Liabilities: Taxes owed on profits up to the date of completion are almost always included as debt-like
  • Unpaid Bonuses: Employee bonus/reward that is linked to performance and accrued within earnings is often included as debt-like
  • Deferred Income: Cash received for goods or services that the company has not yet fully delivered but has a legal obligation to fulfil
  • Bad or Doubtful Debts: Trade receivables that have fallen due within the ordinary course of business but which are either deemed irrecoverable or more likely to become unpaid

Formula

Net Cash/(Debt) = Cash and Cash-Like items - Debt and Debt-Like items

What is Net Working Capital (NWC)?

Net Working Capital (NWC) measures a company's short-term operational liquidity by assessing the difference between current assets and current liabilities.

Formula

Net Working Capital = Current Assets − Current Liabilities

Inclusions and Exclusions

Included in Current Assets

  • Inventory, work-in-progress
  • Trade debtors (accounts receivable)
  • Prepaid expenses
  • Other debts due including those from related parties

Included in Current Liabilities

  • Trade creditors (accounts payable)
  • Accrued expenses
  • Short-term liabilities like payroll
  • Payroll and sales taxes (VAT) payable

Excluded

  • Long-term assets/liabilities (e.g., property, long-term debt)
  • Restricted cash, as it may not be operationally available
  • Deferred Tax, as it is often a non-cash liability

Linking NWC and Cash in M&A

How NWC Converts to Cash

Reduction in NWC Releases Cash

  • Inventory is sold, reducing stock levels and generating cash
  • Debtors (Accounts Receivable) are collected faster, bringing in cash
  • Creditors (Accounts Payable) are extended, temporarily preserving cash

Increase in NWC Consumes Cash

  • Inventory Build-Up ties up cash in stock
  • Debtors Grow as extended credit delays cash inflows
  • Paying Creditors Earlier consumes cash reserves

Why It Matters in M&A

  • NWC Adjustment: Buyers and sellers negotiate a target NWC. Any excess (or deficit) relative to the target is adjusted in the purchase price
  • Double Counting Risk: Nominal ledger items should fall within one of Net Cash or Working Capital calculation
  • Valuation Risk: Cash releases from NWC reductions must be carefully considered to avoid overpayment

Using LTM Averages for setting NWC Targets

NWC is often volatile, impacted by seasonal cycles or operational fluctuations. Buyers typically use the last twelve months (LTM) average to smooth these variations.

Example of 18-Month NWC Trends

Month NWC (£m) LTM Average (£m) Delta to LTM (£m)
Month 1 40 - -
Month 2 42 - -
Month 3 43 - -
Month 4 45 - -
Month 5 44 - -
Month 6 46 - -
Month 7 48 - -
Month 8 50 - -
Month 9 52 - -
Month 10 54 - -
Month 11 55 - -
Month 12 56 47.42 +8.58
Month 13 58 48.50 +9.50
Month 14 60 49.58 +10.42
Month 15 62 50.75 +11.25
Month 16 64 52.08 +11.92
Month 17 66 53.33 +12.67
Month 18 68 54.75 +13.25

Reconciling Enterprise Value to Equity Value

Enterprise Value (EV) represents the value of the business as a whole, while Equity Value (EQV) represents the residual value to shareholders after accounting for cash, debt, and working capital adjustments.

Reconciliation Formula

Equity Value = Enterprise Value + Net Cash/(Debt) + Working Capital Adjustment

Example

  • Enterprise Value (EV): £500m
  • Net Cash/(Debt): (£30m) (net debt, reducing value)
  • Working Capital Adjustment: £10m (surplus NWC, adding value)
  • Equity Value = 500 − (30) + 10 = £480m

This reconciliation ensures all adjustments for cash, debt, and operational liquidity are properly accounted for, aligning the purchase price with the cash economic value.

Understanding these metrics and their interplay ensures fair valuations and mitigates risks of miscalculation during M&A.