In the world of mergers and acquisitions (M&A), the way liabilities are classified can significantly impact the final purchase price and the overall value realised by both sellers and buyers. Most business sales in Australia are structured on a “cash-free, debt-free” basis, where the buyer acquires the business without assuming excess cash or outstanding debt.
In this structure, net working capital (NWC) — typically defined as current assets minus current liabilities, excluding cash and debt — plays a pivotal role in post-closing adjustments. Liabilities classified as part of NWC are incorporated into the operational profile of the business and may not directly reduce the purchase price, whereas those treated as debt or “debt-like” items are often deducted outright from the enterprise value to arrive at the equity value paid to the seller. This distinction isn’t just accounting jargon; it can translate to substantial financial differences, especially for liabilities like GST payable, superannuation payable, and employee provisions, which are common in Australian businesses.
This article explores why proper classification matters, using real-world examples to illustrate the stakes. Whether you’re a seller aiming to maximise proceeds or a buyer seeking to minimise risks, understanding these nuances during due diligence and negotiations is essential for a fair deal.
Understanding Net Working Capital vs. Debt in M&A
Net working capital represents the short-term liquidity needed to run the day-to-day operations of a business. In M&A, it’s often calculated on a normalised basis (e.g., an average over the past 12 months) to set a “target” level that the business should deliver at closing. If the actual NWC at closing exceeds the target, the buyer compensates the seller for the surplus; if it’s below, the seller compensates the buyer for the shortfall. This mechanism ensures the buyer inherits a business with sufficient operational funds to cover immediate obligations without injecting additional capital.
Debt, on the other hand, includes interest-bearing obligations like loans, lines of credit, and shareholder advances. “Debt-like” items extend this to non-interest-bearing liabilities that behave similarly, such as obligations the seller should settle before closing or that could drain cash post-sale. These are typically deducted dollar-for-dollar from the purchase price, reducing the net amount the seller receives. The key difference? NWC liabilities are seen as recurring and integral to operations, while debt-like items are viewed as financing or one-off burdens that shouldn’t transfer to the buyer without adjustment.
In Australian transactions, this classification is often scrutinised during due diligence to avoid disputes. For instance, if a liability is misclassified as debt, it could lower the seller’s net proceeds; if treated as NWC, it remains part of the business’s ongoing profile, potentially preserving value for the seller.
The Financial Impact: Why Classification Matters
Classifying a liability as NWC versus debt directly affects the transaction’s economics.
For sellers, the preference is to classify more liabilities as part of NWC rather than debt. This can lower the target NWC profile and increase the implied goodwill component in the purchase price, delivering higher net proceeds to the seller.
- No Direct Deduction for NWC Items: These are folded into the NWC target. As long as the overall NWC meets the agreed target, there’s no separate subtraction from the purchase price. This benefits sellers by avoiding a direct hit to proceeds and reflects that these liabilities are matched by corresponding assets or revenue streams in the operating cycle. For buyers, it ensures they acquire a functioning business without overpaying for inflated working capital.
- Dollar-for-Dollar Deduction for Debt-Like Items: These reduce the purchase price outright, as the buyer doesn’t want to assume them. Sellers may need to pay them off using sale proceeds or leave cash behind, effectively lowering their net gain. Buyers push for this classification to maximise working capital delivery and minimise post-closing cash outflows.
The stakes are high because misclassification can lead to post-closing disputes, arbitration, or even deal failure. In one analysis, buyers often aim to reclassify items as debt-like to ensure higher operational liquidity post-acquisition, while sellers argue for NWC inclusion to protect value. Additionally, in a cash-free, debt-free deal, the purchase price is adjusted not just for debt but also for deviations in NWC, making accurate categorisation critical for fair valuation.
Key Examples in Australian Contexts: GST, Superannuation, and Employee Liabilities
Australian businesses often deal with specific liabilities tied to tax and employment laws. Here’s how they are typically classified and why it matters:
- GST Payable: This represents Goods and Services Tax collected from customers but not yet remitted to the Australian Taxation Office (ATO). Typically, it’s treated as a current liability within NWC because it’s part of the regular operating cycle, arising from sales and offset by input tax credits or receivables. Classifying it as NWC means it’s not deducted from the purchase price; instead, it’s absorbed in the NWC adjustment. If reclassified as debt-like (e.g., if overdue or unusually large), it could reduce the seller’s proceeds by the full amount, as the buyer might argue it represents a cash outflow not tied to ongoing operations. For sellers, keeping it in NWC preserves value, especially in retail or service businesses where GST is a routine flow.
- Superannuation Payable: Employer contributions to employees’ superannuation funds, often accrued but unpaid at quarter-end, are generally current liabilities included in NWC. They’re operational, linked to payroll, and recur monthly or quarterly. Treatment as NWC avoids a direct deduction, allowing the buyer to assume them as part of the workforce costs. However, if viewed as debt-like (e.g., significant arrears or non-compliance issues), it could be deducted, hitting the seller’s payout and signalling potential regulatory risks to the buyer.
- Employee Liabilities: Provisions for accrued entitlements like annual leave or long service leave are common in Australia under Fair Work laws. These are often classified as NWC if they’re standard and proportional to the workforce, reflecting ongoing employee costs. No deduction occurs if NWC hits the target, benefiting sellers by treating them as operational rather than legacy burdens. Buyers might push for debt-like status if accruals are excessive (e.g., due to long-tenured staff), arguing they require immediate cash settlement post-sale, thus reducing the price.
In practice, these items are negotiated in the heads of agreement (or letter of intent) and detailed in the sale and purchase agreement (SPA). For example, payroll taxes like PAYG are usually in NWC, while income tax liabilities might be debt-like.
Implications for Sellers, Buyers, and Deal Success
For sellers, classifying liabilities as NWC maximises net proceeds by avoiding deductions and framing them as essential to the business’s value. However, over-inflating NWC (e.g., by delaying payments) can backfire during due diligence, leading to downward adjustments.
For buyers, pushing for debt-like classification protects against hidden cash drains and ensures adequate working capital for smooth operations post-acquisition. It also aligns with leverage in financing the deal.
Ultimately, proper classification promotes transparency, reduces disputes, and reflects the true economic reality of the business. In Australia, where regulatory obligations like super and GST are strict, misalignment can expose parties to ATO penalties or employee claims.
Here is an example of how the outcome can change:
Hypothetical Scenario and Table
| Net Proceeds to Seller if Treated as NWC | Net Proceeds to Seller if Treated as Debt-Like | Difference (NWC vs. Debt-Like) | |
| Scenario 1 | Scenario 2 | ||
| Enterprise Value | 20,000,000 | 20,000,000 | |
| Total of Specific items as NWC
(included in lower target NWC; no deduction) |
1,200,000 | ||
| Total of Specific items as Debt
(excluded from higher target NWC; deducted from EV) |
1,200,000 | ||
| Net proceeds | 20,000,000 | 18,800,000 | 1,200,000 |
Assumptions:
- Enterprise Value (EV): $20,000,000
- Other current assets (e.g., receivables, inventory, excluding cash): $5,000,000
- Other current liabilities (e.g., trade payables, always treated as NWC): $2,000,000
- No excess cash or other debt.
- Target NWC is calculated on a normalised historical basis (e.g., average over 12 months).
- If liabilities are classified as NWC: Target NWC = $5,000,000 assets – $2,000,000 other liabilities – specific items’ amounts = lower target.
- If classified as debt-like: Target NWC excludes these items, so = $5,000,000 – $2,000,000 = $3,000,000 (higher target), and the items are deducted separately as debt.
- At closing, balances are assumed to match historical norms (no deviations), so NWC adjustment = $0 in both cases.
- Specific items: GST payable ($400,000), Superannuation payable ($300,000), Employee liabilities ($500,000). Total: $1,200,000.
In this setup, treating items as NWC keeps the target lower and avoids separate deductions, maximising seller proceeds. Treating as debt raises the target (by excluding them from the NWC calc) but deducts them dollar-for-dollar, reducing proceeds.
To illustrate, consider this hypothetical example of 2 scenarios in the table below, showing how classification affects net proceeds to the seller.
How DMA Assists
Navigating these complexities requires experienced guidance. With over 290 completed transactions and 26 years of M&A advisory experience across Australian mid-market businesses, DMA’s team handles NWC negotiations and liability classifications as a core part of deal structuring every day.
Those without this specialist knowledge, when negotiating with counterparts who understand the ropes, will inevitably leave money on the table and miss out on achieving their best justifiable outcome.
Contact DMA today to ensure your next transaction maximises value.
Author: CFI Australia/DMA MD, M&A Advisor Tony Brown
Disclaimer: This article provides general information only and does not constitute financial, legal, or tax advice. Every transaction is unique and specific circumstances may affect how liabilities are classified. Professional advice should be sought for individual situations.
