Working Capital’s Impact on a HCB Transaction

AssetDuring a healthcare M&A transaction, the amount of money that a company has historically made is obviously important as a way for a buyer to see into the future of the business.  However, what is also important during a transaction is the amount of working capital that is available to the company at the time of the sale.  The Ambulatory M&A Advisor takes a look at how working capital is calculated, why it matters in a transaction, and some of the difficulties involved when discussing working capital during a transaction.

Jim Lloyd, Principal, PYA states that working capital is a business’ current assets minus its current liabilities.  It is basically the capital that a company needs to fund its daily operations.

Accounts receivable is typically a significant current asset – especially with many healthcare companies, Lloyd says.

“However, some healthcare entities, such as small physician practices, etc. often do not record accounts receivable on their balance sheet. In such cases, the balance sheet must be adjusted to reflect outstanding accounts receivable correctly.  Working capital is important for many reasons such as the time it typically takes to convert accounts receivable into cash, which can then be used to fund operating expenses, etc. That is the basic issue with working capital. It’s the funds needed to fund normal operating expenses due primarily to the time lag in converting accounts receivable into cash,” Lloyd says.

Josh Hedrick, Senior Analyst for Kraft Analytics LLC says that in short, working capital is the capital that is available to run the day to day operations, make payroll, pay for inventory, pay the electric bill.

“It is most often defined as the current assets of the business, the cash, the inventory, accounts receivable, minus the current liabilities.  For transaction purposes, assets or liabilities that are not conveyed are excluded.  For example, if the buyer is not taking the debt, you would exclude the current portion of the long-term debt,” Hedrick says.

“What makes it unique in the healthcare industry is that the accounts receivable is primarily owed by a third party payor rather than the direct consumer of services.  Most time, the largest form of working capital is what is owed by the people that a business is providing services to.”

Ken Conner, CPA, shareholder, Elliot Davis Decosimo says that every business is going to have to have working capital and part of the purchase price of a going concern is working capital. Given a variety issues around healthcare receivables, many times the receivables are not acquired and the receivables are left with the buyer, but the purchase price reflects the value of the receivables retained by the seller.

“It typically is part of an all inclusive price and if the seller were to retain working capital, it would reduce the price below a typical valuation.  It is one of the assets that a buyer typically expects to acquire. When a buyer expects to acquire working capital, a buyer should critically evaluate accounts receivable in a healthcare deal.  They need to find out what the collectability is, what the age of the accounts are and who the payors are.  That is the biggest thing they need to look for,” Conner says.

“The second biggest thing to look out for is unrecorded liabilities.  How good is the seller at accruing expenses. To the extent that it is a physician practice being acquired or something similar that operates on a cash basis, they are not going to have a good working capital number because they are only recording the cash as it comes in or goes out.”

Conner says the clients that are acquiring these physician practices are typically not buying the accounts receivable and are not typically acquiring working capital.  There is no record to what it is, so you have got to go recreate it and honestly nobody wants to take on that risk.

Typically working capital is a significant component of an entity’s value and therefore could significantly impact the purchase price, according to Lloyd.

Lloyd explains that a certain level of working capital is typically assumed in connection with determining the value/purchase price.  However, since actual working capital changes daily, a post-transaction true-up adjustment is often needed to account for the difference in the working capital assumed vs. actual working capital as of the transaction closing date.  If the actual working capital is greater than the assumed amount, the purchase price if often adjusted up for the difference and vice versa.

“Post transaction working capital adjustments often result in disputes between the buyer and seller; therefore, it is very important that the buyer perform adequate due diligence on working capital (among other items) prior to closing on the transaction,” Lloyd says.

According to Hedrick, when dealing with purchase price and working capital, there are two common scenarios.  Under the first scenario, a buyer and a seller agree to either target ratio or a dollar amount of working capital that is going to remain in the business. The seller would then pull down the cash until they meet that target.  Often a portion of the deal proceeds are held in an escrow account to basically true up the working capital post-transaction.

“Under that scenario, what you are doing is saying, “We are going to have X in working capital after the transaction is completed.’  On the back side, you then remeasure to true up your working capital.  The second scenario that we see often is that working capital is fully excluded from deals.  The seller will collect their receivables, and pay all of their payables.  Then on day one of the deal there is effectively zero dollars of working capital.  Working capital is then injected by the buyer.  You keep your cash, you keep your receivables, then we will just put in whatever cash is needed to run the operation.  That infusion is effectively an offset to the purchase price,” Hedrick says.

With working capital comes obvious difficulties.  Conner says that one of these is the measurement of the value of accounts receivable, defining working capital – the buyer has to take time to understand what is there and the Seller needs to honestly assess the value before closing, so there are not surprises.

Lloyd says that misunderstandings and disagreements over working capital are certainly common occurrences in connection with M&A transactions.

“For example, many physician practices and other smaller healthcare entities often utilize “cash” basis financial statements which exclude many working capital components such as accounts receivable and accrued expenses. Accordingly, the owner/sellers of these entities sometimes have difficulties understanding working capital – which is really more of an “accrual” basis of accounting concept.  For example, I have seen a number of physician practice transactions where the selling physicians assumed that they would be retaining cash and accounts receivable; whereas, the buyer included those amounts in connection with determining the fair market value purchase price.  Such misunderstandings can lead to transactions not being consummated and/or disputes among the parties,” Lloyd says.

Hedrick says that in order to avoid misunderstandings, the number one thing that buyers need to understand is the cash cycle of a target.  In a healthcare setting specifically, this means that participants in the deal need to understand the payor mix.

“It is not uncommon for buyers to underestimate the cash cycle and then that would lead to a cash crunch after the transaction is completed.  That is a big deal because a lot of the times you are using a lot of your credit capacity to borrow the funds necessary to do the deal, making it harder to get credit extended after the deal is done,” Hedrick says.

Lloyd adds that under or over stated working capital can also have an impact on the value and purchase price due to its connection with the subject entity’s earnings.

“For example, earnings before interest, taxes, depreciation, and amortization (“EBITDA”) is a common metric used in connection with developing the offered purchase price. If the entity’s working capital is materially overstated or understated – then EBITDA will most likely also be overstated or understated. For example, accounts receivable is typically a material current asset for many healthcare companies. If accounts receivable is overstated, then the entity’s historical revenues will also be overstated. Likewise, if accrued expenses, which is a current liability, are understated, operating expenses on the income statement will also be understated.  This could have a material impact on the purchase price if the buyer utilized a multiple of EBITDA to help determine the value,” Lloyd says.

“Buyer due diligence is critically important to help avoid misunderstands and disputes involving working capital. Significant/in-depth due diligence may be difficult to justify for some small transactions but high level analytical due diligence, such as ratio analysis, benchmark comparisons, and trending analysis can generally be performed very efficiently. I think it’s important for buyers and sellers to understand that even small transactions can result in large and costly post-transaction disputes.”

If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or








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