“Normal” working capital is not a number that exists independently of the specific business — it is a peg the parties build from that business’s own historical pattern, then measure against on closing day.
Key takeaways
Treadstone Law’s guidance on setting a working capital target states the underlying purpose plainly: “a working capital target is meant to reflect the level of working capital the business normally needs to operate.” (treadstonelaw.ca) That is a business-specific figure, not a rule of thumb applied across every deal — a business that carries sixty days of receivables and holds three months of inventory needs a meaningfully different working capital cushion than one that collects cash daily and carries almost no inventory at all, even at an identical revenue level.
The target is built from the business’s own historical pattern, and treadstonelaw’s guidance on seasonal businesses is specific about which historical figures to use: “historical, same-period figures rather than a flat annual average,” so that a business closing at the peak or the trough of its cycle is not unfairly penalized or advantaged purely by the timing of the closing date. (treadstonelaw.ca) The guidance applies to both sides of the table equally, and recommends raising seasonality “early in negotiations” so the adjustment mechanism is built fairly before either party has a specific number to fight over.
The determination is not left to either party’s judgment on closing day. Treadstone Law’s explainer is direct on this: “the purchase agreement is supposed to define the methodology, the target figure, and the process in advance,” precisely “to avoid an ad hoc argument on closing day itself.” (treadstonelaw.ca) Mechanically, the seller typically prepares an estimated closing statement shortly before closing based on the agreed accounting policy, which sets the initial price adjustment; the buyer then reviews the actual post-closing figures and prepares a final closing statement using the same methodology, and any difference between the two triggers a true-up payment. (treadstonelaw.ca)
Two disagreements are common, and they are different problems. The first is a straightforward numbers dispute, usually resolved, per treadstonelaw’s guidance, by “a defined dispute-resolution process, commonly referring the disagreement to an independent accountant whose determination on the accounting question is treated as final.” (treadstonelaw.ca) The second is subtler and more common than it sounds: a dispute over which accounting treatment is correct, where both sides may be right under a defensible reading of generally accepted practice. Treadstone Law’s explainer on this specific failure mode notes it “is not usually about someone acting improperly; it more often reflects that generally accepted accounting practice can permit more than one reasonable way to treat certain items.” (treadstonelaw.ca) Its recommended fix is preventative rather than curative: a well-drafted mechanism addresses it directly by “specifying the exact accounting policies, and often the specific line items and estimation methods, to be used for the closing statement well in advance,” so the dispute never has room to occur in the first place. (treadstonelaw.ca)
Treadstone Law’s description of a quality of earnings report lists “working capital trends over time” as one of the areas the report is built to cover, alongside normalizing earnings and testing revenue sustainability. (treadstonelaw.ca) That is a deliberate pairing, not a coincidence: a business whose earnings have been normalized upward by aggressive add-backs, but whose working capital has simultaneously been drawn down to unsustainable levels to fund operations, is not actually the healthier business the adjusted earnings figure alone would suggest. Testing the two together is what catches that combination.
The peg itself is usually built from current assets less current liabilities, excluding whatever debt is being repaid or assumed at closing — cash, receivables, inventory and prepaid expenses on one side, payables, accrued liabilities and any current debt staying with the business on the other. Exactly which line items count, and how, is the specific detail treadstonelaw’s guidance on accounting-standard disputes warns needs to be settled in advance: whether a receivable is included at full face value or net of an allowance for doubtful accounts, whether a prepaid deposit counts as working capital or sits outside it, and which liabilities are excluded because the buyer is not assuming them. (treadstonelaw.ca) None of those choices has one universally correct answer under generally accepted accounting practice — which is exactly why leaving them undefined in the purchase agreement is what manufactures a dispute the agreement itself could have prevented.
A landscaping supply business has a strong March-through-October season and a much quieter winter. Its historical working capital at the end of each of the last three Marches averaged $410,000, driven by inventory built up ahead of the spring rush; at the end of each of the last three Decembers, it averaged $185,000, once seasonal inventory has been sold down and receivables collected. If the deal closes in April, using a flat annual-average target of roughly $300,000 would unfairly penalize the seller: April working capital naturally sits closer to the March peak than to the annual average, so the seller would be handing over a business at a level that looks like a shortfall against the wrong benchmark. Applying treadstonelaw’s same-period approach instead, the parties set the target using historical April figures specifically — averaging $395,000 across the same three years — and the closing statement is measured against that number rather than the flat annual average. The seller is neither rewarded nor penalized for a closing date that happened to land during the business’s natural seasonal peak.
Related: why the same-period principle matters beyond working capital, how the inventory count feeds directly into the working capital number, when a working capital shortfall belongs in the price versus an indemnity
No. It is set from the specific business’s own historical pattern rather than a generic formula, precisely because two businesses at the same revenue level can need very different cushions depending on their receivables, inventory and payment cycles. (treadstonelaw.ca)
Neither party unilaterally — the purchase agreement is supposed to fix the methodology and process in advance, and most agreements route a genuine disagreement to an independent accountant whose determination is treated as final. (treadstonelaw.ca)
Under the standard mechanism, the seller typically owes the buyer the shortfall as a true-up payment once the final closing statement is prepared against the same agreed methodology used for the estimate. (treadstonelaw.ca)
A short call is enough to work out whether an annual average is the wrong benchmark for this deal.
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