Understanding Net Working Capital: A Key Formula Used in Business Valuation

When valuing a business, it is essential to consider various financial metrics and factors contributing to its overall worth. Among these, net working capital stands out as a critical, yet occasionally overlooked, component.

What is Net Working Capital?

Based on standard accounting definitions, net working capital is equal to a company’s current assets minus its current liabilities. In a valuation context, however, the definition and calculation of net working capital are slightly different. While still starting with current assets less current liabilities, net working capital from a valuation standpoint typically excludes cash, non-operating assets, debt, and debt-like liabilities. As a result, net working capital for valuation purposes typically comprises accounts receivable, inventory and prepaid expenses, less accounts payable, and accrued expenses.

For valuation purposes, cash, non-operating assets, debt, and debt-like liabilities are excluded from the calculation of net working capital. These items are driven by how management chooses to capitalize the company rather than the company’s core operational interactions with customers and vendors. Further, many valuation approaches determine a company’s enterprise value, which is the cash-free and debt-free value of the business. This calculation of net working capital fits neatly into the definition of enterprise value, which assumes that the company maintains a suitable level of working capital exclusive of cash and debt. The company’s cash and non-operating assets are added to the enterprise value, while the debt and debt-like liabilities are subtracted to arrive at its equity value.

How Does Net Working Capital Impact a Company’s Value?

Net working capital impacts the value of a company in two ways. First, the company may have excess or deficient net working capital on hand as of the valuation date. To the extent that a company has excess net working capital as of the valuation date (the amount above the required level for the company to operate), the excess balance is added to the valuation conclusion in order to determine the company’s actual value. The opposite also holds true where any deficient net working capital balance (the amount below the required level for the company to operate) would be subtracted in determining the company’s actual value.

The second way net working capital impacts a company’s value is by considering investments in net working capital required to fund the company’s growth when applying the income approach. As a company grows, the net working capital balance must often grow by carrying higher accounts receivable and inventory balances to support its higher sales volume and revenue. This reinvestment of profits to support the growth in net working capital means there is less cash available for distribution to the owners of the company, which impacts the income approach value.

What Drives a Company’s Net Working Capital?

Several factors influence a company’s net working capital position:

1. Industry and Business Cycle: Each industry has differing working capital requirements. Industries, including manufacturing or retail, typically require higher levels of net working capital due to inventory requirements and receivables management. Service-oriented sectors, including consulting firms and legal practices, do not typically require high levels of working capital as they are not as asset-intensive. Additionally, the stage of the business cycle can impact net working capital requirements.
2. Revenue and Growth: Companies experiencing growth may require additional working capital to support increased sales, manage accounts receivable, and finance inventory. Rapid growth can strain a company’s net working capital position if not managed effectively.
3. Seasonality: Businesses that experience seasonal fluctuations in demand may need to maintain higher levels of net working capital during peak periods to fund increased inventory and accounts receivable balances.
4. Supplier and Customer Relationships: The payment terms negotiated with suppliers and the average collection period from customers can significantly impact a company’s net working capital position. Longer payment terms or slower collections can tie up cash in net working capital.

Conclusion

Net working capital is a crucial component of business valuation since it impacts both a company’s enterprise value via its projected cash flows and its equity value via excess or deficient net working capital levels as of the valuation date. In addition, net working capital for valuation purposes is more nuanced than simply taking current assets minus current liabilities, as is often done when calculating net working capital in an accounting context. Therefore, it is important that any valuation analysis appropriately consider the impact of net working capital in order to arrive at an accurate and supportable value.