What Is Net Working Capital and Why Don’t I Keep My Receivables?

Brief

This article explains Net Working Capital (NWC), why it matters to business operators, and how it impacts M&A transactions, ensuring you’re prepared for key financial decisions.

Introduction

Net Working Capital (NWC), also known as Working Capital, is the difference between a company’s current assets and current liabilities, reflecting its liquidity and short-term financial health. If you work in corporate finance, manage a business with a robust accounting team (e.g., a Controller, VP of Finance, or CFO), or are exploring a business sale, you’ve likely encountered NWC. This metric shows what the company is owed and what it owes others in the near term, making it a critical measure for operators and investors.

What does NWC tell me and who looks at this?

• Liquidity Health Check: NWC indicates whether a company can cover short-term obligations with its current assets. A positive NWC suggests the ability to pay bills, suppliers, and employees comfortably, while a negative NWC can be strategic (e.g., in retail, where customers pay upfront) or a warning sign (e.g., in manufacturing, indicating reliance on supplier credit or poor cash management).

• Operational Efficiency: NWC reveals how effectively a company manages cash flow in inventory, receivables, and payables. Low or negative NWC may signal slow collections or excess inventory, requiring closer scrutiny.

• Financial Flexibility: Robust NWC enables a business to navigate challenges, fund operations, and invest in growth without relying on external financing.

• Business Discipline: Efficient NWC management reflects strong leadership and operational controls, signaling a well-run business.

• Lending & Creditworthiness: Lenders evaluate NWC to assess loan eligibility. Weak NWC may restrict financing or increase borrowing costs.

• M&A Valuation: In acquisitions, buyers set a target NWC in the purchase agreement. If actual NWC at closing falls below this target, the seller’s payout decreases (and vice versa).

Note on Positive or Negative NWC: Some businesses, like retailers, intentionally run negative NWC by collecting customer payments before paying suppliers, boosting cash flow as they grow. In contrast, for capital-intensive or slow-collection industries (e.g., manufacturing, construction, B2B services), negative NWC can signal overreliance on supplier credit or poor cash management, risking inability to pay short-term bills. Bottom line, negative NWC is great if you’re paid upfront, but trouble if collections lag behind your bills. Monitor AR Days to stay on top of this.

What is Net Working Capital, a Basic Definition

Net Working Capital (NWC) excludes cash and short-term borrowings (e.g., lines of credit or current portions of long-term debt) because it focuses on operational assets and liabilities, which directly impact operating cash flow. Think of NWC as the financial fuel powering your business’s day-to-day operations.

Below, Exhibit I illustrates quarterly NWC balances for McSample Industrial Services, excluding cash and short-term debt to highlight operational liquidity.

Exhibit I – McSample Industrial Services Net Working Capital Example

What Does Net Working Capital Tell Us?

Exhibit II below enhances the NWC example with additional metrics, such as receivables and payables trends, to provide deeper insights into operational efficiency.

Exhibit II – McSample Industrial Services Net Working Capital Analysis

Note: Last Twelve Months (LTM), also known as Trailing Twelve Months (TTM), refers to the past 12 months of financial data, providing a rolling view of performance (e.g., February 2023 to January 2024 for an LTM January 2024 view).

Net Working Capital. From December 2022 to December 2024, McSample Industrial Services’ NWC grew from $4.555 million to $5.737 million, an increase of $1.182 million. This growth indicates the company invested an additional $1.182 million in operations, but further analysis is needed to assess efficiency. Exhibit II shows this trend with key metrics such as receivables days, highlighting operational impacts.

Change in Net Working Capital. Tracking Changes: Monitoring NWC changes (e.g., month-to-month or year-over-year) reveals cash flow drivers, helping identify operational strengths or inefficiencies.

Last Twelve Months (“LTM”) Revenue and Net Working Capital as a % of LTM Revenue. Comparing NWC to LTM revenue shows how efficiently capital is used as the business scales. In healthy, growing companies, NWC typically rises, but disproportionate increases may signal inefficiencies, requiring closer management attention.

Accounts Receivable Days (AR Days or Days Sales Outstanding, DSO): This metric measures the average time to collect customer payments. For example, McSample Industrial Services’ AR Days increased from 95 in December 2022 to 111 in December 2024, tying up an additional $0.613 million in cash. In industries like construction, “paid when paid” clauses may extend AR Days to 80, but exceeding this suggests collection inefficiencies. Reducing AR Days for McSample Industrial Services from 95 to 80 could free up $0.174 million in cash, as shown in Exhibit III.

To reduce AR Days, consider establishing standard operating procedures around billing and collections such as following up with customers one week after an invoice has been sent to confirm all information is correct, incentivizing early payments, and conducting a weekly Accounts Receivable meeting to review the status of all invoices and delegate follow ups.

Exhibit III – Accounts Receivable Days Impact on Net Working Capital

Inventory Turns. This metric, also called inventory turnover, measures how often inventory is sold annually. McSample Industrial Services turns inventory 4.5 times per year, holding about 2.7 months of stock. Higher turns reflect efficient inventory management, freeing up cash faster.

Accounts Payable Days. This metric measures the average time to pay vendors. McSample Industrial Services’ AP Days decreased from 10 days ($0.187 million) in December 2022 to 8 days ($0.165 million) in December 2024, consuming $0.022 million in cash. AP Days below 20 may indicate tight payment terms or limited supplier credit, hurting cash flow. Extending AP Days to 20 (within standard 30-day terms) could free up $0.226 million, as shown in Exhibit IV.

Exhibit IV – Accounts Payable Days Impact on Net Working Capital

Accrued Expenses: These liabilities, like unpaid wages or taxes, are tracked as a percentage of LTM revenue. Rising percentages may signal liquidity issues, while stable or declining trends indicate strong expense management.

Other Accounts (Prepaids, Other Current Assets, Other Current Liabilities). Other Accounts: Prepaid expenses, other current assets, and liabilities (e.g., deferred revenue) can distort NWC trends. Monitoring them separately ensures accurate analysis of AR, inventory, and AP.

• Prepaid Expenses: Advance payments (e.g., rent, insurance) reduce cash but don’t directly impact operations.

• Other Current Assets: These include short-term advances, deposits, or non-trade receivables.

Tracking these items prevents misinterpretation of core NWC trends.

Takeaway

Understanding NWC components empowers proactive cash flow management, supporting efficient and sustainable growth. Remember, NWC is an Investment. Like purchasing equipment, increasing NWC consumes cash, while decreasing NWC generates cash, impacting overall liquidity. NWC is not just how fast your accounting team can collect, there are strategic considerations here, as managers increasing NWC (e.g., offering extended AR terms or paying vendors early) can drive competitive advantages, like faster delivery or market share gains. However, uncontrolled NWC growth signals a need for better oversight.

How does Net Working Capital Impact Cash Flow

Net Working Capital (NWC) significantly impacts cash flow by acting as a source or use of cash, depending on whether it increases or decreases. Below, Exhibit V shows McSample Industrial Services’ cash flow statement, highlighting NWC’s role in operating cash flow, including receivables, payables, and inventory changes.

For example, in 2023, McSample Industrial Services generated $1.466 million in net income (after taxes) plus $0.324 million from a cashless depreciation expense being added back, less -$0.565 million in NWC that was invested in the business, which resulted in $1.225 million in Cash Flow from Operations. Here, we can see that as the business grew, so did the primary components of net working capital, Accounts Receivable, Inventory and prepaids. While current liabilities grew, overall NWC grew by $0.565 million.

Cash Flow from Investing was -$0.375 million, driven by capital expenditures on assets like trucks and equipment. Cash Flow from Financing was -$0.307 million due to term loan repayments.

Total Cash Flow for 2023 was $0.543 million, increasing the cash balance from $0.815 million (December 2022) to $1.358 million (December 2023).

Exhibit V – McSample Industrial Services Cash Flow Statement

In summary, monitoring NWC changes helps operators optimize cash flow, ensuring liquidity for operations and growth. Regular analysis of NWC components empowers better financial decision-making.

 How Does Net Working Capital Show up in M&A Transactions

Introduction

In M&A transactions, Net Working Capital (NWC) ensures the acquired company has sufficient liquidity to operate post-closing by setting a target NWC level, typically based on a 12-month average.

Exhibit VI – McSample Industrial Services 12 Month Average Net Working Capital

Exhibit VI shows an average NWC target of $5.503 million for McSample Industrial Services, reflecting the liquidity needed for historical operations. Buyers base purchase prices on cash flows (EBITDA minus capital expenditures and NWC changes), so delivering $5.503 million in NWC ensures the expected cash flow.

Note: EBITDA multiples are often discussed but oversimplify valuation, much like valuing a home solely by price per square foot. Actual valuations account for cash flows, including NWC adjustments.

Net Working Capital Target and Adjustment

McSample Industrial Services’ NWC fluctuates seasonally, peaking in December and dipping in March. Sellers may prefer to close in March to retain cash from reduced NWC, while buyers may target December to benefit from future cash generation.

To ensure fairness, a Net Working Capital (NWC) target and adjustment are included in the purchase agreement, following these steps:

1. Calculate NWC and agree on figures, using a 24-month spreadsheet adjusted for items like bad debt reserves, accrued expenses, and inventory levels.

2. Set an NWC target, typically a 12-month LTM average, though a 3- or 6-month average may suit rapidly growing or declining businesses.

3. Include an NWC adjustment in the purchase agreement to increase or decrease the purchase price based on delivered NWC.

4. Estimate NWC at closing to determine if the buyer increases the price or the seller leaves cash behind.

5. Audit the opening balance sheet 90–120 days post-closing to finalize payments.

Exhibit VII – McSample Industrial Services Simplified  NWC Adjustment Example

The above exhibit shows a company with a single account for NWC, that being Accounts Receivable. In this instance, the agreed upon NWC Target is $3.300 million. When the Company has elevated Accounts Receivable above the target, an adjustment is owed to the Seller for delivering “more than what is necessary” to run the business. For example when Accounts Receivable increases in March 2023 to $3.350 million, an adjustment of $50,000 is owed the Seller, as they have delivered more Accounts Receivable than is needed.

When the Accounts Receivable balance has been collected against and it is below the target, additional cash is owned the Buyer. Consider that when Accounts Receivable comes down it is because cash has been collected. For example when Accounts Receivable comes down in February 2023 to $3.200 million, an adjustment of $100,000 is owed the Buyer as the Company has less Accounts Receivable than is needed.

Exhibit VIII – McSample Industrial Services Net Working Capital Adjustment Example

The above exhibit shows a comprehensive NWC adjustment for hypothetical closings against the $5.503 million target. Most transactions are “cash free, debt free,” meaning the seller retains cash and pays off debts (e.g., lines of credit, truck loans, term loans). Reducing receivables generates cash for the seller, but removing it requires the buyer to fund operations, increasing the effective purchase price.

When buying a business, think of it like purchasing a work truck: you expect it to come with enough fuel (Net Working Capital, or NWC) to run. Without sufficient NWC, the buyer must inject additional funds to keep operations going; with excess NWC, the seller delivers extra value. Setting an NWC target ensures fairness for both parties.

 Exhibit IX – McSample Industrial Services Seller Retains Receivables

Assume in June 2024 a transaction takes place. The seller retained $3.973 million in Accounts Receivable as part of the sale. As a result, NWC delivered was $1.436 million (Current Assets minus Current Liabilities, excluding receivables), compared to $5.410 million if receivables were included. This reduced NWC level leaves the buyer with less operational liquidity.

Exhibit X – McSample Industrial Services NWC Adjustment vs Seller Keeps Receivables

This exhibit compares cash flow from operations under two scenarios: starting July with $0.0 million in receivables versus $3.973 million. In the no-receivables scenario, the first quarter (ending September) sees a -$3.014 million Cash Flow from Operations loss, as Accounts Receivable grow from $0.0 million to $4.142 million without generating cash inflows. The buyer must fund this gap, effectively increasing the cost of acquiring the business’s cash flows. In the NWC Adjustment scenario, the normal seasonal cash flow of elevated income statement profits and investment in NWC is experienced.

Key Takeaways

• Valuation ≠ NWC: The purchase price reflects earnings, not the level of operational assets like receivables or inventory.

• NWC Target Ensures Fairness: It ensures the buyer receives sufficient NWC to operate the business post-closing.

• Receivables Remain: Like inventory and payables, receivables are essential for ongoing operations.

• Timing Neutrality: A well-set NWC target eliminates advantages or penalties from closing timing.

Conclusion

Net Working Capital (NWC) is a vital indicator of short-term financial health and operational efficiency, deserving the same attention as physical assets like equipment.

Tracking NWC components—AR Days, AP Days, and revenue ratios—enables operators to optimize cash flow and prepare for M&A. Regular analysis identifies whether NWC changes support growth or signal strain.

Best practices include reviewing a monthly cash flow statement with NWC as a separate line and consulting a financial advisor to set an optimal NWC target for transactions