Navigating M&A: The Hidden Risks of Working Capital

Introduction: The Illusion of Operating Health

Working capital is often viewed as a measure of operational efficiency. But in M&A, it can be a minefield. Hidden liabilities, aggressive accounting, and timing mismatches can distort the apparent health of a company. Understanding these traps—especially in customer payables, inventory, and accrued liabilities—is essential for CFOs tasked with evaluating or executing transactions.

Customer Payables: The Mirage of Deferred Revenue

One of the most misunderstood elements in working capital is customer payables, particularly deferred revenue. In a SaaS acquisition, the seller reported a $12 million deferred revenue balance. To the untrained eye, this suggested strong sales. But further review revealed that a significant portion came from multi-year contracts with front-loaded payments and unfulfilled obligations.

Deferred revenue represents a liability, not an asset. When misaligned with delivery capabilities or cost recognition, it can create future margin compression.

We now reconcile deferred revenue with contract terms, delivery schedules, and cost curves. We also assess refund risk, which is often unrecorded but material in subscription businesses.

Inventory: Where Write-Offs Hide

Inventory is another common area for misrepresentation. Overstated inventory can inflate working capital and disguise operational inefficiencies.

In one industrial acquisition, we found $8 million in obsolete inventory that had not been written down due to lax internal controls. This materially overstated EBITDA and working capital.

We perform detailed SKU aging analysis and tie inventory levels to historical sales patterns. If inventory turnover is inconsistent or declining, it raises red flags.

Accrued Liabilities: The Unseen Debt

Accrued liabilities often include bonuses, commissions, warranty reserves, and legal contingencies. These are ripe for underreporting.

In a technology transaction, the target had accrued only 60 percent of annual bonuses due at year-end, relying on a board vote that had not yet occurred. This understated liabilities by $2.5 million and inflated normalized EBITDA.

We insist on a month-by-month accrual reconciliation, review board resolutions, and examine historical payout practices. Accrued expenses must be matched to both legal obligations and behavioral precedent.

The True-Up Mechanism: Avoiding Post-Close Disputes

Most deals include a working capital true-up at close. But if the baseline is flawed, the true-up becomes a source of conflict.

We draft detailed working capital definitions in the purchase agreement, customized to the target’s accounting practices. This avoids ambiguity and ensures apples-to-apples comparisons.

We also recommend using normalized working capital, not just trailing twelve-month averages. This accounts for seasonality, growth, and cyclical effects.

Conclusion: The CFO as Forensic Strategist

CFOs must approach working capital not as an accounting afterthought but as a strategic risk area. Inaccuracies here can lead to overpayment, post-close disputes, and impaired returns.

A forensic approach to customer payables, inventory, and accruals—combined with clear true-up mechanisms—can turn working capital from a trap into a source of negotiating leverage.

Insight

Over the last three decades, I have reviewed countless financial statements, but the greatest deal risks are rarely in the headline figures. They hide in the trenches of working capital. For all the attention we pay to EBITDA multiples and ARR metrics, the true test of deal quality is often embedded in how well a company manages its working capital—or how well it hides its inefficiencies within it.

Customer payables, especially deferred revenue, are frequently misunderstood by both buyers and sellers. Many SaaS businesses proudly point to rising deferred revenue balances as proof of growth. But unless you interrogate those balances, you may discover you are buying obligations rather than opportunity. In one case, a target claimed $12 million in deferred revenue. Our deeper analysis showed that nearly $5 million of that related to contracts that would take more than 18 months to fulfill, with escalating support costs and refund provisions hidden in the fine print. We adjusted our valuation accordingly. That deal would have been a costly mistake had we relied on surface-level diligence.

Deferred revenue is not a measure of cash flow health. It is a promise to deliver. When those deliveries require higher marginal costs or include unrecognized obligations, the margin erosion can be sharp. We now routinely crosswalk every material deferred revenue line item with its respective delivery contract, fulfillment schedule, and cost trajectory. It is painstaking work, but it separates informed acquirers from hopeful ones.

Inventory presents an entirely different kind of trap. It is not only a question of how much there is, but of what it is worth. In a manufacturing transaction in 2019, we walked into a data room to find pristine balance sheets—and warehouses full of parts no longer in production. The company had not written down obsolete stock in three years. EBITDA was overstated by over $6 million. If we had relied only on management’s top-level roll-forward schedules, we would have overpaid significantly.

We now conduct granular SKU-level analysis, stratify by aging and sales velocity, and perform walk-throughs of inventory turnover calculations. We also dig into any manual adjustments or overrides in the inventory control system. One client had their CFO bypassing automated write-down rules with management overrides, inflating reported working capital. Without forensic diligence, these issues remain invisible until post-close impairment charges surface.

Accrued liabilities are often the most hidden elements in working capital. These include bonuses, commissions, taxes, legal contingencies, and service obligations that companies under-accrue to inflate performance. One deal in a tech services business nearly collapsed when we discovered that only 60 percent of year-end bonuses had been accrued. The CFO insisted it was customary to accrue once the board approved. The board had approved bonuses the same way for the last five years. Behavior is policy in accounting.

We now make it a best practice to conduct historical accrual-to-payout reviews, verify board minutes or compensation committee resolutions, and review internal email chains where commitments may have been made informally. This provides the real picture of what has been promised and what has been accounted for.

When it comes to deal structure, the working capital true-up mechanism is the final line of defense. Unfortunately, many deals rely on vague definitions of working capital or adopt industry templates that fail to reflect the target’s specific accounting practices. We now insist on customized definitions, down to the chart of accounts level. We also distinguish between operational working capital and non-recurring or one-time adjustments. One seller included a litigation reserve reversal in working capital. That led to a post-close dispute that nearly resulted in arbitration.

Normalized working capital is another best practice we apply across all our deals. Simply taking the trailing twelve-month average is insufficient. Businesses have cycles. A retail business with year-end seasonality or a services firm with quarterly billing peaks must be analyzed on a seasonally adjusted and context-aware basis. This means aligning the working capital peg to not just historic averages but the projected operational cadence of the business post-close.

From a strategic perspective, diligence around working capital can serve as more than risk mitigation. It can become a negotiating lever. In one acquisition, we identified a recurring pattern of under-accruals and high obsolete inventory write-offs that management had papered over for years. Our analysis resulted in a downward adjustment of the purchase price and inclusion of a $3 million escrow to cover any future discrepancies. That escrow turned out to be necessary when a warranty accrual shortfall surfaced six months later.

The most important takeaway I can offer any CFO is that working capital is not just an operational metric. It is a balance sheet language through which companies tell stories—sometimes true, sometimes fiction. It is your job to decode it. With rigor. With skepticism. And with cross-functional diligence.

In every deal, our finance team works in tandem with operations, legal, and tax to ensure that what looks good on paper reflects operational reality. This means reviewing sales contracts, procurement cycles, fulfillment rates, payroll runs, and vendor terms—not just trial balances. In high-growth environments, where accounting maturity may lag behind commercial success, this alignment becomes even more critical.

In summary, working capital diligence is the invisible scaffolding of deal quality. It reveals the cracks behind the painted walls. When done well, it informs not just valuation, but integration planning, financial forecasting, and covenant setting. When done poorly, it leads to regret.

If you want to avoid paying for value that is not there—or leaving value on the table—scrutinize working capital like you would a balance sheet full of hidden cash. Because in many ways, that is exactly what it is

Disclaimer: This article is for informational purposes only and does not constitute legal, financial, or accounting advice. Always consult with qualified professionals before executing financial transactions.