Most business owners understand the concept of an earnings multiple or an income-based approach to valuing their operating company. As a valuation expert, many of the questions asked when reviewing the report involve the concept of net working capital (“NWC”). In this two-part article, we will discuss the concept of net working capital and how it impacts the value of a company and how target net working capital calculations impact the closing of a transaction upon the sale of a business.
What is NWC?
NWC is defined as, in its most basic form, current assets minus current liabilities. However, in the real world, transactions occurring between a buyer and a seller exclude cash and debt from this equation. It is important to understand that a buyer of a company expects the seller to deliver a balance sheet that is free from debt and cash but includes normal levels of working capital. Cash and debt are removed from the equation because buyers don’t like to “purchase” cash and buyers don’t want to be beholden to existing lenders / debt holders. Therefore, many analysts will describe their analysis of net working capital as a “cash-free, debt-free” basis.
Why is analyzing NWC important?
NWC is a function and indication of the Company’s operating cycle and its ability to cover expenses over the cycle. A general rule of thumb, for most non-seasonal industries, is that a company should be able to fund three (3) months of its expenses using its current assets. As part of analyzing working capital, an analyst should be able to observe the subject company’s operating cycles for its collection of receivables and payment of payables.
When a company is valued, to prepare for selling or another purpose, an analyst will use various techniques to analyze the required NWC needed to keep a company operating at normal levels. If a company holds “excess working capital”, the excess amount is considered additional value and is classified as a non-operating asset. If the company is deemed to have insufficient working capital, the Company’s value will be adjusted lower to account for the deficit to the NWC acceptable level.
Can you give us an example?
Assume ABC Company is being valued using a Market Approach and a multiple of five times (5x) Earnings before Interest, Taxes, Depreciation, and Amortization (“EBITDA”). The Company generates $1,000,000 EBITDA, resulting in a value of $5 million. ABC Company generally holds cash of $1 million and receivables of $1.5 million. Its payables total $500,000, and the company holds current debt of $300,000. In this example, the company’s net working capital is $2 million (cash of $1MM + receivables of $1.5MM – payables of $0.5MM). On a cash-free, debt-free basis, the company holds $1 million of net working capital.
Based on research and analysis of the company’s last several years of operating results and industry-specific metrics (ratios and percentages of sales), the analyst determines the net working capital required to be held by the business is $0.5 million. In this case, the company would have excess working capital that is not deemed necessary to fund ongoing operations of the business as shown below:
Debt-free, Cash-Free NWC $1,000,000
Less: Required NWC $500,000__
Subtotal $500,000
Add: cash $1,000,000
Excess (deficit) NWC $1,500,000
In this example, $1,500,000 of the company’s cash reserves would be deemed a non-operating asset and added to the equity value. Since the valuation is based off an EBITDA multiple, debt has already been accounted for in arriving at the value. Consequently, the final valuation of the company would be calculated as follows:
Market Approach Value (5x EBITDA) $5,000,000
Excess working capital $1,500,000
Total Equity Value $6,500,000
In part-two of this article, we will examine two (2) common methods used to analyze a company’s NWC and how the working capital target impacts the purchase price in a sale of a company.
