Business Valuation – Working Capital Analysis

Authored By: Mark W. Norris, Partner

The analysis of working capital tends to be overlooked by many valuation analysts.  If the underlying theory includes a “hypothetical buyer”, an analysis of working capital as of the valuation date is warranted.  Most, if not all actual sales transactions of businesses include a provision regarding a working capital requirement as of the transaction date.  If that represents the “real world”, then the valuation analysis should include an adequate analysis of working capital.

Working capital is defined as current assets less current liabilities exclusive of structured debt.  It is really a measurement of the timing of cash flow.  Let’s consider the importance of working capital in the following example of a start-up company.

  • Day 1: The company starts with no cash, no accounts receivables, no inventory to sell, and no accounts payables.
  • Days 1 to 30: The company invests in inventory that turns over every 30 days in the amount of $50,000.
  • Days 1 to 60: The company incurs payroll costs of $100,000.
  • Days 1 to 30: The company incurs other operating costs totaling $200,000 that are due on day 60.
  • Days 1 to 30: The company generates revenue in the amount of $500,000 that will not be collected until day 60.

Based on the above fact pattern, the company needs the following working capital to fund costs before it receives any cash receipts:

Amount needed for inventory$50,000
Amount needed for payroll100,000
Amount needed for operating costs200,000
Total cash outlay before any cash receipts$350,000

This is not a one-time issue for the above company since the above costs will continue to be incurred each month before accounts receivables are collected to fund the costs.  Any owner of a business realizes the importance of dealing with the funding of working capital.  In fact, the funding of working capital for companies that are growing represents a significant issue since the actual costs increase before revenue is collected.

From a business valuation perspective, the analysis of working capital includes two components; (1) the calculation of a surplus or deficit in working capital as of the valuation date (a balance sheet issue), and (2) the ongoing need for working capital (a cash flow issue).

Calculation of Working Capital Surplus/Deficit

There are numerous ways to calculate a working capital surplus or deficit as of the valuation date.  We typically consider the following:

  1. Historical working capital on a cash free/debt free basis as a percentage of revenue.
  2. Historical operating cycle in days.
  3. Industry working capital on a cash free/debt free basis as a percentage of revenue.
  4. Industry operating cycle in days.

Historical Working Capital on a Cash-Free/Debt-Free Basis as a Percentage of Revenue.

After reviewing the percentages produced (working capital divided by revenue) , the valuation analyst must determine what percentage to use in the analysis.  Based on the years included in the analysis, this can be a straight average, weighted average, the latest year, etc.  The overall goal is to use the percentage that is expected to be incurred by the company in the future.  The current revenue of the company is multiplied by the percentage selected to produce the estimated working capital requirement as of the valuation date.  This is compared to the actual working capital to determine the surplus or deficit.

One of the criticisms of this method is that it assumes that the company has been utilizing an adequate amount of working capital during the period used in the analysis.  This is not necessarily the case as many companies operate with either excess or deficit working capital for a variety of reasons.  Therefore, the working capital calculated using this method may not represent a required working capital for the company, especially in the eyes of a buyer.  It is also important to examine how the industry and the industry resources, such as Integra, RMI and Ibis World, calculate the working capital ratios you plan to use in your working capital comparison.  Some industries such as car dealerships have unique manners of financing their working capital.

Historical Operating Cycle in Days

The operating cycle in days is calculated by calculating the average number of days to collect accounts receivables (365 days divided by [revenue divided by accounts receivable]) , plus the average number of days for inventory to turnover (365 days divided by [cost of sales divided by inventory]), less the average number of days to pay vendors (365 days divided by [cash expenses divided by accounts payable]).  Similar to the above calculation, the valuation analyst can review the operating cycle in days for all years reviewed and calculate a straight average, weighted average, the latest year, etc.  The current year’s cash expenses is used to calculate the working capital requirement.  An example of this calculation is as follows:

Plus: Days to collect Accounts Receivable45
Plus: Days invested in inventory30
Less: Days to pay vendors(30)
Operating Cycle in Days45
Annual Cash Expenses$1,000,000
Daily Cash Expenses$2,740
Cash Expenses for 45-Day Operating Cycle$123,300

The above $123,300 represents the required working capital as of the valuation date.  An advantage of using this method is that it is specific to the operating cycle of the company being valued.

Industry Working Capital on a Cash-Free/Debt-Free Basis as a Percentage of Revenue.

This method is identical to the historical working capital on a cash-free/debt-free basis as a percentage of revenue except the data is sourced from companies in the same industry.  While it is important to compare this information to the percentage applicable to the company being valued, and try to understand why there are differences, the valuation analyst should not blindly assume that this percentage represents the best estimate of the required working capital.  For example, assume the company being valued has a material concentration of client base whereby it is subject to an average accounts receivable collection period that is twice the average for the industry.  Using the industry’s average collection period for accounts receivables could materially impact the working capital calculation.  The valuation analyst would essentially be valuing the industry rather than the Company.

Industry Operating Cycle in Days

Again, this method is identical to the historical operating cycle in days except the data is sourced from companies in the same industry.  Similar to the industry working capital as a percentage of revenue above, the valuation analyst should not blindly assume that this percentage represents the best estimate of the required working capital.

After developing the above working capital calculations, the valuation analyst should use their judgment in concluding the working capital requirement.  This requirement is then compared to the actual working capital outstanding at the valuation date to determine if there is a surplus or deficit.

Calculation of On-Going Working Capital Requirement

Once the above working capital requirement has been calculated, developing the on-going working capital requirement is simple.  The required working capital developed above is divided by the latest year’s revenue to produce the percentage of working capital to revenue.  This increase in the next year’s revenue is multiplied by this percentage to determine the working capital requirement.  This amount represents one of the adjustments when converting from normalized net earnings to normalized net cash flow.

Using the above example, assuming the latest year’s revenue totaled $1,250,000, the required working capital percentage would be 9.9% ($1,250,000 divided by $123,300).  Assuming revenue was estimated to grow 4%, or $50,000 ($1,250,000 times 4%) the required working capital adjustment would be $4,950 ($50,000 time 9.9%).

Summary

In conclusion, determining whether there is a surplus or deficiency in working capital as of the valuation date represents an important of the valuation analysis.  The on-going working capital requirement also must be taken into consideration as it affects the cash flows which often drive the valuation.

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