Working Capital in Business Valuations: A Thorough Analysis

BY MARK W. NORRIS, CPA/ABV, CVA, MAFF, ASA

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The following article was prepared by its author(s). The opinions expressed in the article represent the author(s)’s and may not reflect the view and/or opinion of Vallit Advisors and its staff. Views/opinions are based on the specific facts and circumstances of each Matter.

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Mark W. Norris is a co-founder and managing member of Vallit Advisors, LLC. Mr. Norris has over 42 years of accounting and business operations experience and has been providing business valuation consulting services for 28 years. He provides diverse litigation support services to the legal community including business valuations, expert testimony, economic loss calculations, and consulting on fraud detection and prevention. Mark can be reached at 443-482-9500 Ext. 102 or mnorris@vallitadvisors.com

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This article presents a thorough analysis of working capital as it relates to business valuations. In many cases, both valuation practitioners and the valuation professional literature place little emphasis on analyzing working capital. Developing a supportable and credible working capital analysis is a key component of a business valuation. This article presents multiple methods to analyze working capital.

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Introduction

Throughout my career, I have always placed emphasis on the working capital component in the business valuations I have been involved with. This is probably due to the many business valuations I have been involved in that were for M&A transactions. In addition, I have been involved with at least one litigation matter that focused on working capital in an ESOP transaction and my firm has been involved with many purchase price disputes where working capital is part of the disagreement.

I have also observed that many business valuation analysts place little emphasis on that part of their analysis. In addition, it’s interesting that some of the textbooks we typically refer to also don’t place much emphasis on working capital, as evidenced by the number of pages dedicated to it as follows:

• Pratt: Valuing a Business – The Analysis and Appraisal of Closely Held Companies (1 page)
• Hitchner: Financial Valuation – Applications and Models (1 page)
• Trugman: Understanding Business Valuation – A Practical Guide to Valuing Small to Medium Sized Businesses (1 page)
• Damodaran: Investment Valuation – Tools and Techniques for Determining the Value of Any Asset (5 pages)

 

Relevant Definitions

I believe it would be worthwhile to review relevant definitions related to working capital. These include the following:

Working Capital. Current assets less current liabilities. However, for valuation purposes, we typically remove structured debt. And, as you will see later in the examples, we also exclude cash.

Cash Conversion Cycle. The amount of time (in days) it takes for a company to collect receivables, sell inventory, and pay bills. Cash conversion cycle = days receivable + days inventory – days payable.

Days Accounts Receivable (ASA). Days of A/R is based on total credit sales.

Days Inventory (ASA). Days of inventory is based on the materials component of COGS.

Days Accounts Payable (ASA). Days of A/P based on all expenses that flow through A/P and, where relevant, cost of goods sold.

Days Accounts Payable (CFA). Days of Payables Outstanding or DPO is the final component of the Net Operating Cycle and it gets subtracted from the Operating Cycle (hence the “net”). It measures the number of days of Accounts Payable the company has outstanding relative to their purchases of inventory or COGS.

An interesting observation about the above definitions as it relates to Days Accounts Payable is that although the ASA definition includes days of A/P based on all expenses that flow through A/P, the CFA definition only includes the A/P relative to purchases of inventory or COGS. It is my opinion that the ASA definition is more accurate. In addition, if working capital data and related Days A/P data is being pulled from various industry statistics databases, one should determine how the database is calculating Days A/P. Another important consideration is if the database is averaging businesses that report their balance sheet on a cash basis (i.e., with no A/R or A/P).

 

How is Working Capital Used in a Business Valuation

The working capital analysis is used to determine if there is a surplus or deficiency in working capital as of the valuation date. I refer to this as the “balance sheet” impact. Any surplus in working capital is added to the enterprise value of the company under the income approach. A deficiency in working capital is deducted from the enterprise value of the company under the income approach.

In addition, the working capital analysis is used to determine the working capital requirement when converting from net earnings to net cash flow when using the capitalized cash flow (“CCF”) and discounted cash flow (“DCF”) methods.

 

Potential Adjustments to Current Assets and Current Liabilities

Current assets and current liabilities should be reviewed for the purpose of making the following adjustments applicable to the working capital analysis:

• Remove cash. Cash will be added back to the enterprise value to produce the value of equity. Note that working capital can be calculated with or without operating cash being considered.
• Remove any non-operating assets and liabilities. Cash will be added back to the enterprise value to produce the value of equity.
• Remove interest-bearing debt. Cash is deducted from the enterprise value to produce the value of equity.
• Adjust deferred revenue. By definition, deferred revenue represents revenue that has not been earned yet. Therefore, from a cash-flow perspective, only the costs required to earn the revenue represent a use of funds. Therefore, an adjustment should be made to decrease the deferred revenue amount to these estimated costs.
• Adjust gift certificates/warranties. Similar to the deferred revenue adjustment discussed above, an adjustment should be made to decrease the gift certificate amount to the estimated costs incurred to earn the gift certificate. In rare cases, cash can be a positive inflow for companies that are growing and collect monies in advance.
• Adjust for prepaid expenses.
• Adjust for accrued tax liabilities.
• Adjust for cash basis taxpayers who do not report accruals like A/R and A/P.

 

Example of the Importance of Working Capital for a Start-Up Company

The following fact pattern illustrates the working capital needs 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 on day 60:

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 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 actual costs typically increase before revenue is collected.

 

Methods for Calculation of Working Capital Surplus/Deficit

The following represent typical methods for calculating working capital:

1. Historical working capital on a cash free/debt free basis as a percentage of revenue.
2. Historical cash conversion cycle in days.
3. Industry working capital on a cash free/debt free basis as a percentage of revenue.
4. Industry cash conversion 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 Cash Conversion Cycle in Days

The cash conversion 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]), plus other working capital assets, less the average number of days to pay vendors (365 days divided by [cost of sales divided by accounts payable]), less other working capital liabilities.

Similar to the historical working capital on a cash free/debt free basis as a percentage of revenue calculation above, the valuation analyst can review the cash conversion cycle in days for all years reviewed and calculate a normalized cash conversion cycle using a straight average, weighted average, the recent year, etc. The normalized cash conversion cycle is then applied to normalized revenue and cost of sales to calculate the working capital requirement.

 

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. This dichotomy often presents itself when valuing government contractors.

 

Industry Cash Conversion Cycle in Days

Again, this method is identical to the historical cash conversion 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 working capital to revenue. The 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.

 

Working Capital Example for an ESOP Transaction

In this example, a dispute arose over an ESOP valuation of “Alpha Company” and the treatment of a line of credit (or “Revolver”) as interest-bearing debt or working capital. Vallit was retained as an expert witness to show that, so long as all relevant adjustments to a business valuation are made, the value impact of such a choice in treatment should be negligible.

In this instance, a balance sheet and statement of cash flows was not projected. However, that can sometimes assist the parties in a dispute to see where the cash is going and how the balance sheet is being impacted directly by changes in working capital.

The following comments apply to the above analysis:

• Vallit’s work is supported in fundamental business valuation theory.
• As presented here, Vallit excluded the Revolver from working capital, which increased the net working capital indication to 15.3 percent of sales as of the Valuation Date.
• One source for normalized working capital requirements is to consider industry levels. Here, Vallit considered levels from guideline public companies (GPCs) that were also used in the Market Approach analysis.
• These GPCs indicated 10 percent of sales for a normalized level of working capital. Using this 10 percent level yields an excess working capital indication.

The following adjustments were made to the BV Advisor Report to analyze Alpha Company on an “Apples-to-Apples” Basis:

1. Reclassify the Revolver to interest-bearing debt rather than working capital.
2. In the Market Approach, GPC Method, Vallit adjusted for the Revolver-related interest expense for both Alpha Company and the GPCs (when calculating EBIT and EBITDA).
3. In the Market Approach, GPC Method, Vallit adjusted for cash and equivalents in its enterprise value calculation because Vallit excluded cash from the working capital analysis.
4. In the Market Approach, GPC Method, Vallit recalculated enterprise value to include any Revolver debt for the GPCs in their interest-bearing debt.
5. In the Income Approach, DCF Method, Vallit adjusted EBITDA for Revolver-related interest expense.
6. In the Income Approach, DCF Method, Vallit adjusted the required additional working capital cash flow item for the non-Revolver & non-cash working capital level.
7. In the Income Approach, DCF Method, adjusted the selected WACC for considerations related to: equity beta used in the CAPM (and sourced from the GPCs), company-specific risk premium level, and equity and debt allocation in the capital structure.

 

Conclusion

This article presented a thorough analysis of working capital as it relates to business valuations. In many cases, both valuation practitioners and the valuation professional literature place little emphasis on analyzing working capital. Developing a supportable and credible working capital analysis is a key component of a business valuation. This article presented multiple methods to analyze working capital.