Working capital is one of those topics that sounds basic on the surface but becomes surprisingly nuanced when you get into the details — especially in the context of M&A transactions and valuation. Most finance students learn the textbook definition early on, but many candidates stumble when interviewers ask how working capital actually affects deal value, how net working capital adjustments work in purchase agreements, or how working capital shows up in a DCF. This guide will walk you through everything you need to know about working capital in a valuation and deal context.
What Is Working Capital?
At the most basic level, working capital is defined as current assets minus current liabilities. It represents the short-term liquidity available to a business to fund its day-to-day operations. The main components include:
- Current assets: Accounts receivable, inventory, prepaid expenses, and other short-term assets that will be converted to cash within one year.
- Current liabilities: Accounts payable, accrued expenses, deferred revenue (current portion), and other obligations due within one year.
However, in the context of valuation and M&A, bankers typically refer to net working capital (NWC), which often excludes cash and cash equivalents from current assets and excludes the current portion of debt from current liabilities. The reason is that cash and debt are handled separately in enterprise value to equity value bridge calculations. What you are trying to isolate with NWC is the operating working capital — the capital tied up in the business’s normal operations.
Why Working Capital Matters in Valuation
Working capital matters in valuation for two primary reasons: it affects free cash flow projections, and it is a critical component of deal structuring in M&A.
Working Capital in a DCF
In a discounted cash flow (DCF) analysis, changes in working capital are a key component of unlevered free cash flow. The formula for unlevered free cash flow is:
UFCF = EBIT x (1 – Tax Rate) + D&A – Capital Expenditures – Changes in Net Working Capital
The “changes in net working capital” line captures how much additional capital the business needs to fund its operations as it grows (or how much capital is released as the business shrinks). Here is the key intuition:
- An increase in NWC is a use of cash. If accounts receivable grows because customers are paying more slowly, the company has earned revenue but has not collected cash. That is cash tied up in the business — it reduces free cash flow.
- A decrease in NWC is a source of cash. If accounts payable grows because the company is taking longer to pay suppliers, it is effectively using supplier financing to fund operations. That frees up cash.
When building a DCF model, you typically project working capital as a percentage of revenue. For example, if historically a company’s NWC has been approximately 10% of revenue, you might assume that relationship holds in the projection period. As revenue grows, NWC grows proportionally, and the incremental investment in working capital reduces free cash flow each year.
Getting this right matters for your terminal value calculation as well. In the terminal year, you need to include a normalized level of working capital investment consistent with the assumed long-term growth rate. If you forget to include the working capital change in the terminal year, you will overstate the company’s free cash flow in perpetuity.
Working Capital in LBO Models
Working capital plays a similar role in LBO models. Changes in NWC affect the company’s cash flow available for debt repayment. A business with favorable working capital dynamics — meaning it generates cash as it grows (like a subscription business that collects cash upfront) — will have more cash available to pay down debt, which improves returns for the financial sponsor. Conversely, a working-capital-intensive business (like a manufacturer with large inventory and receivable balances) will require ongoing investment in working capital, reducing cash available for debt paydown.
Working Capital Adjustments in M&A Deals
This is where working capital gets particularly important — and particularly nuanced — for investment bankers. In most private M&A transactions, the purchase agreement includes a working capital adjustment mechanism. Here is how it works and why it exists.
The Concept: The Working Capital “Peg”
When a buyer and seller agree on a purchase price, the price is typically based on an assumed level of “normal” working capital that the business needs to operate. This assumed level is called the working capital target or working capital peg. It is usually based on an average of the target’s NWC over some historical period — for example, the trailing twelve-month average or a twelve-month average excluding seasonal outliers.
The idea is straightforward: the buyer is paying for a business that comes with a normal level of operating working capital. If the seller delivers more or less working capital than the agreed-upon target at closing, the purchase price should be adjusted accordingly.
How the Adjustment Works
The purchase agreement will specify:
- The working capital target (peg). This is the dollar amount of NWC that is considered “normal” for the business.
- The definition of working capital. This is one of the most heavily negotiated sections of a purchase agreement. It specifies exactly which accounts are included and excluded from the NWC calculation. Buyers and sellers will argue about whether certain items — like deferred revenue, accrued bonuses, or tax receivables — should be included.
- The true-up mechanism. At closing, the seller delivers an estimated closing NWC. After closing (typically within 60-90 days), the buyer prepares a final NWC calculation based on actual closing balances. If actual NWC is above the target, the buyer pays the seller the difference. If actual NWC is below the target, the seller pays the buyer the difference.
Some deals include a “collar” around the peg — a range (say, plus or minus $500,000) within which no adjustment is made. This avoids disputes over small, immaterial differences.
Why This Matters for Bankers
As a junior banker working on an M&A transaction, you will often be involved in analyzing the target’s working capital — calculating historical averages, identifying seasonal patterns, and flagging any unusual items that might distort the NWC calculation. You may also help the deal team negotiate the working capital definition and target. This is particularly important in M&A advisory roles where you are advising either the buyer or seller on deal terms.
Sellers sometimes try to inflate working capital before closing by accelerating collections (reducing receivables) and delaying payments to suppliers (increasing payables). Buyers are on the lookout for this kind of manipulation, which is why the post-closing true-up mechanism exists.
Working Capital in the Enterprise Value Bridge
Understanding how working capital relates to the enterprise value bridge is critical. Enterprise value is typically defined as equity value plus net debt plus minority interest minus associates — and it is meant to capture the value of a company’s core operations independent of its capital structure.
Operating working capital is implicitly embedded in enterprise value. When you calculate enterprise value using a multiple like EV/EBITDA (as in comparable company analysis), the resulting EV already assumes a normal level of working capital. This is why working capital adjustments in M&A are so important — they ensure that the buyer gets the normal level of working capital that the agreed enterprise value assumed.
Key Working Capital Metrics to Know
Bankers and investors use several metrics to analyze working capital efficiency:
- Days Sales Outstanding (DSO): Measures how quickly the company collects its receivables. DSO = (Accounts Receivable / Revenue) x 365. Lower is generally better.
- Days Inventory Outstanding (DIO): Measures how long inventory sits before being sold. DIO = (Inventory / COGS) x 365. Lower is generally better for most businesses.
- Days Payable Outstanding (DPO): Measures how long the company takes to pay suppliers. DPO = (Accounts Payable / COGS) x 365. Higher DPO means the company is using supplier financing.
- Cash Conversion Cycle (CCC): CCC = DSO + DIO – DPO. This tells you how many days it takes for a dollar invested in working capital to come back as cash. A lower or negative CCC is favorable.
These metrics are useful in a three-statement financial model because they help you project working capital line items based on the company’s operating characteristics rather than just applying blanket assumptions.
Working Capital Considerations by Industry
Working capital intensity varies significantly by industry, and this is important to understand when analyzing different sectors:
- Software/SaaS companies typically have negative net working capital because they collect subscription payments upfront (creating deferred revenue, a current liability) and have minimal inventory or receivables. This is a favorable working capital dynamic.
- Manufacturing companies tend to be working-capital-intensive because they carry large inventory balances and may have long collection cycles on receivables.
- Retail companies vary — those with large inventory positions need significant working capital, but those that collect cash at the point of sale and negotiate long payment terms with suppliers can have favorable dynamics.
- Professional services firms tend to have moderate working capital needs, driven primarily by accounts receivable (billing clients for work performed) with minimal inventory.
When you are working in a sector-focused group like technology investment banking or healthcare investment banking, understanding the typical working capital dynamics of that sector is essential for building accurate models and advising clients.
Common Interview Questions on Working Capital
Here are questions you should be prepared to answer in your investment banking interviews:
“How does an increase in working capital affect free cash flow?” An increase in NWC reduces free cash flow because additional cash is being tied up in the business’s operations.
“If accounts receivable increases by $10 million, what happens to cash flow?” Cash flow decreases by $10 million (pre-tax). The company has recognized revenue but has not collected cash.
“Why is working capital excluded from enterprise value calculations?” Operating working capital is not excluded from enterprise value — it is embedded in it. What is excluded is excess cash (above what is needed for operations) and current debt, because those are financing items, not operating items.
“What is a working capital peg?” The working capital peg is the agreed-upon “normal” level of net working capital in an M&A transaction. The purchase price is adjusted dollar-for-dollar based on whether actual closing NWC is above or below the peg.
Make sure you also review our free resources and technical cheatsheet for quick reference on these and other valuation concepts.
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