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Working Capital Reserves

A little more than a year ago (July 12, 2022), Kevin Gould authored a Deal Note®, addressing the Working Capital Target, how it is calculated and how it is used in the Working Capital True-up. In today’s Deal Note®, I will discuss accounting reserves and how they impact the Working Capital Target.

As Kevin discussed, the Working Capital Target is the agreed amount of Working Capital to be delivered to the buyer on the closing date, which often is calculated as the 12-month average of the sum of a) accounts receivable (net of reserves) and b) inventory (net of reserves) less i) accounts payable and ii) accrued expenses. Over the past 22-years we have seen reserves netted against the Working Capital accounts in almost every case, primarily because it is a requirement under Generally Accepted Accounting Principles and because it is a standard requirement for most buyers.

If you have Audited financial statements, all necessary reserves will be addressed by your accountants, in your annual financial statements. However, even large publicly traded companies do not have audited monthly statements. Because the Working Capital Target is typically calculated using monthly figures, these results do not have the benefit of an auditor’s review of the Working Capital reserves.

Accordingly, one of the first steps we recommend our clients take, when we start a sale process, is to have an accountant review the company’s monthly reserves for the Working Capital accounts. If you are a company with a large accounting staff, you may be able to do this in-house. If you have a smaller accounting department, you may want to retain external accountants to help.

The following are some of the types of reserves that your accountants (in-house or external) may want to review: accruals for uncollected receivables, obsolete and excess inventory, accruals for warranty expense, and accrued vacation. In a future Deal Note®, we will address the different types of external accounting engagements that can be utilized to support a sale process, including Agreed Upon Procedures (AUP) and Quality of Earnings (QofE).

Regardless of whether this accounting work is done in-house or externally, it is critical that the historical monthly financial statements, to be utilized in the Working Capital Target, include the appropriate amount of reserves. If not, then the Working Capital True-up may result in a significant payment owed post-closing to the buyer from the seller, which often leads to post-closing disputes and litigation, as we wrote about in a Deal Note® in February.

Have a great day, everyone.

Bill Alderman