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.