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  • Achille Ekeu, MBA, CVA

How to Determine Working Capital in Business Valuation?

Generally Accepted Accounting Principles (“GAAP”) follow the rule Current Assets minus Current Liabilities equals Working Capital. This is NOT the working capital formula that should be utilized in business valuation.

As we know, working capital is an integral part of calculating a company’s equity cash flow or the invested capital cash flow. Instead of leaving the calculation to guesswork, the valuator must perform statistical testing of the historical balance sheet and income statement to test for correlation of the working capital in a business valuation context.

James R. Hitchner was one of the first to define Net Cash Flow in his book Financial Valuation, Application, and Models in the following manner.

Net income after tax

Plus: depreciation, amortization, and other non-cash charges

Less: incremental working capital needs

Less: incremental capital expenditure needs

Plus: new debt principal in

Less: repayment of debt principal

Equals: net cash flow direct to equity

The word incremental is extremely important when determining the company’s working capital for each future period.

For example, if a company has $2,000,000 in sales and has earned a profit of $75,000 it is natural to assume (and important to understand) that it has performed well enough to cover all of its fixed and variable costs and overhead. If the company is expected to increase its sales in the next year by $500,000, it is reasonable to understand that it would be necessary to consider what will it cost the company to attain this new level of revenue. What would it take to go from $2,000,000 in sales to $2,500,000 in sales? Remember, it performed well enough to attain a profit at the $2,000,000 sales level so it must only NEED what amount of working capital to attain the next additional $500,000 in sales NOT for next year’s $2,500,000 in sales. Therefore, this additional (incremental) amount of revenue requires what amount of incremental working capital.

You may not have available to you (yet) the forecasted financial statements so you must perform tests of the working capital in order to properly detail and provide support for the change in working capital required in the cash flow calculation. This process WILL provide you cogent support for the percentage of incremental working capital when forecasting the future periods.

Therefore, for business valuation purposes we will follow Aswath Damodaran, Ph.D. (“Damodaran”) who is the Professor of Finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation. In his book Investment Valuation, Tools and Techniques for Determining Value of Any Asset, Second Edition on page 261 he defines working capital in the following manner.

Working capital is usually defined to be the difference between current assets and current liabilities. However, we will modify that definition when we measure working capital for valuation purposes.

We will back out cash and investments in marketable securities from current assets. This is because firms invest cash in Treasury bills, short-term government securities, or commercial paper, especially in large amounts. While the return on these investments may be lower than what the firm may make on its real investments, they represent a fair return for riskless investments. Unlike inventory, accounts receivable, and other current assets, cash then earns a fair return and should not be included in measures of working capital. Are there exceptions to this rule? When valuing a firm that has to maintain a large cash balance for day-to-day operations of a firm that operates in a market in a poorly developed banking system, you could consider the cash needed for operations as a part of working capital.

We will also back out all interest-bearing debt – short-term and the portion of the long-term debt that is due in the current period – from the current liabilities. This debt will be considered when computing the cost of capital and it would be inappropriate to count it twice.

Think of it this way even though Damodaran does not explicitly say it. The Net Income is a proxy for the cash build-up within the business. By starting the cash flow analysis with net income, it includes an amount that will inure to the cash balance. Therefore, by excluding cash in the BV-Working Capital calculation it will not be counted twice.

Stated again more simply, Damodaran teaches that the BV-WC (business valuation-working capital) is the result of (Current Assets less Cash), minus (Current Liabilities plus the Current Portion of the Long-Term Debt). The reason for this analysis is that Net Income is a proxy for cash and secondly debt principal payments are made from net income. To “exclude” them from the calculation eliminates the double-counting effect.

Therefore, consider the following when calculating the changes (Delta) in the BV-WC.

Thank You,

Achille Ekeu, MBA, CVA


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