Working capital in valuation (2024)

Working capital in valuation

Workingcapital is usually defined to be the difference between current assets andcurrent liabilities. However, we will modify that definition when we measureworking capital for valuation purposes.

• We will back out cash and investments in marketable securities from current assets. This is because cash, especially in large amounts, is invested by firms in treasury bills, short term government securities or commercial paper. 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 or 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 Ð short term debt and the portion of long term debt that is due in the current period Ð from the current liabilities. This debt will be considered when computing cost of capital and it would be inappropriate to count it twice.

Willthese changes increase or decrease working capital needs? The answer will varyacross firms.

Thenon-cash working capital varies widely across firms in different sectors andoften across firms in the same sector. Figure 10.2 shows the distribution ofnon-cash working capital as a percent of revenues for U.S. firms in January2001.

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Illustration10.7: Working Capital versus Non-cash Working Capital Ð Marks and Spencer

Marksand Spencer operates retails stores in the UK and has substantial holdings inretail firms in other parts of the world. In Table 10.9, we break down thecomponents of working capital for the firm for 1999 and 2000 and report boththe total working capital and non-cash working capital in each year:

Table10.9: Working Capital versus Non-cash Working Capital: Marks and Spencer

The non-cash working capital issubstantially higher than the working capital in both years. We would suggestthat the non-cash working capital is a much better measure of cash tied up inworking capital.

EstimatingExpected Changes in non-cash Working Capital

While we can estimate the non-cash working capital changefairly simply for any year using financial statements, this estimate has to beused with caution. Changes in non-cash working capital are unstable, with bigincreases in some years followed by big decreases in the following years. Toensure that the projections are not the result of an unusual base year, youshould tie the changes in working capital to expected changes in revenues orcosts of goods sold at the firm over time. The non-cash working capital as apercent of revenues can be used, in conjunction with expected revenue changeseach period, to estimate projected changes in non-cash working capital overtime. You can obtain the non-cash working capital as a percent of revenues bylooking at the firmÕs history or at industry standards.

Should you break working capital downinto more detail? In other words, is there a payoff to estimating individualitems such as accounts receivable, inventory and accounts payable separately?The answer will depend upon both the firm being analyzed and how far into thefuture working capital is being projected. For firms where inventory andaccounts receivable behave in very different ways as revenues grow, it clearlymakes sense to break down into detail. The cost, of course, is that itincreases the number of inputs needed to value a firm. In addition, the payoffto breaking working capital down into individual items will become smaller aswe go further into the future. For most firms, estimating a composite numberfor non-cash working capital is easier to do and often more accurate thanbreaking it down into more detail.

Illustration10.8: Estimating Non-cash Working Capital Needs Ð The Gap

Asa specialty retailer, the Gap has substantial inventory and working capitalneeds. At the end of the 2000 financial year (which concluded January 2001),the Gap reported $1,904 million in inventory and $335 million in other non-cashcurrent assets. At the same time, the accounts payable amounted to $1,067million and other non-interest bearing current liabilities of $702 million. Thenon-cash working capital for the Gap in January 2001 can be estimated.

Non-cashworking capital = $1,904 + $335 - $1067 - $ 702 = $470 million

InTable 10.10, we report on the non-cash working capital at the end of theprevious year and the total revenues in each year:

Table10.10: Working Capital Ð The Gap

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Thenon-cash working capital increased by $307 million from last year to this year.When forecasting the non-cash working capital needs for the Gap, we haveseveral choices.

• One is to use the change in non-cash working capital from the year ($307 million) and to grow that change at the same rate as earnings are expected to grow in the future. This is probably the least desirable option because changes in non-cash working capital from year to year are extremely volatile and last yearÕs change may in fact be an outlier.
• The second is to base our changes on non-cash working capital as a percent of revenues in the most recent year and expected revenue growth in future years. In the case of the Gap, that would indicate that non-cash working capital changes in future years will be 3.44% of revenue changes in that year. This is a much better option than the first one, but the non-cash working capital as a percent of revenues can also change from one year to the next.
• The third is to base our changes on the marginal non-cash working capital as a percent of revenues in the most recent year, computed by dividing the change in non-cash working capital in the most recent year into the change in revenues in the most recent year, and expected revenue growth in future years. In the case of the Gap, this would lead to non-cash working capital changes being 15.06% of revenues in future periods. This approach is best used for firms whose business is changing and where growth is occurring in areas different from the past. For instance, a brick and mortar retailer that is growing mostly online may have a very different marginal working capital requirement than the total.
• The fourth is to base our changes on the non-cash working capital as a percent of revenues over a historical period. For instance, non-cash working capital as a percent of revenues between 1997 and 2000 averaged out to 4.5% of revenues. The advantage of this approach is that it smoothes out year to year shifts, but it may not be appropriate if there is a trend (upwards or downwards) in working capital.
• The final approach is to ignore the working capital history of the firm and to base the projections on the industry average for non-cash working capital as a percent of revenues. This approach is most appropriate when a firmÕs history reveals a working capital that is volatile and unpredictable. It is also the best way of estimating non-cash working capital for very small firms that may see economies of scale as they grow. While these conditions do not apply for the Gap, we can still estimate non-cash working capital requirements using the average non-cash working capital as a percent of revenues for specialty retailers of 7.54%.

Toillustrate how much of a change each of these assumptions can have on workingcapital requirements, Table 10.11 forecasts expected changes in non-cashworking capital using each of the approaches. In making these estimates, wehave assumed a 10% growth rate in revenues and earnings for the Gap for thenext 5 years.

Table10.11: Forecasted Working Capital Changes: The Gap

Thenon-cash working capital investment varies widely across the five approachesthat we have described here.

NegativeWorking Capital (or changes)

Canthe change in non-cash working capital be negative? The answer is clearly yes.Consider, though, the implications of such a change. When non-cash workingcapital decreases, it releases tied-up cash and increases the cash flow of thefirm. If a firm has bloated inventory or gives out credit too easily, managingone or both components more efficiently can reduce working capital and be asource of positive cash flows into the immediate future Ð 3, 4 or even 5 years.The question, however, becomes whether it can be a source of cash flows forlonger than that. At some point in time, there will be no more inefficiencies leftin the system and any further decreases in working capital can have negativeconsequences for revenue growth and profits. Therefore, we would suggest thatfor firms with positive working capital, decreases in working capital arefeasible only for short periods. In fact, we would recommend that once workingcapital is being managed efficiently, the working capital changes from year toyear be estimated using working capital as a percent of revenues. For example,consider a firm that has non-cash working capital that represent 10% ofrevenues and that you believe that better management of working capital couldreduce this to 6% of revenues. You could allow working capital to decline eachyear for the next 4 years from 10% to 6% and, once this adjustment is made,begin estimating the working capital requirement each year as 6% of additionalrevenues. Table 10.12 provides estimates of the change in non-cash workingcapital on this firm, assuming that current revenues are $1 billion and thatrevenues are expected to grow 10% a year for the next 5 years.

Table 10.12: Changing Working CapitalRatios and Cashflow Effects

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Canworking capital itself be negative? Again, the answer is yes. Firms whosecurrent liabilities that exceed non-cash current assets have negative non-cashworking capital. This is a thornier issue that negative changes in workingcapital. A firm that has a negative working capital is, in a sense, usingsupplier credit as a source of capital, especially if the working capital becomeslarger as the firm becomes larger. A number of firms, with Walmart and Dellbeing the most prominent examples, have used this strategy to grow. While thismay seem like a cost-efficient strategy, there are potential downsides. Thefirst is that supplier credit is generally not really free. To the extent thatdelaying paying supplier bills may lead to the loss of cash discounts and otherprice breaks, firms are paying for the privilege. Thus, a firm that decides toadopt this strategy will have to compare the costs of this capital to moretraditional forms of borrowing. The second is that a negative non-cash workingcapital has generally been viewed both by accountants and ratings agencies as asource of default risk. To the extent that a firmÕs rating drops and interestrates paid by the firm increase, there may be costs created for other capitalby using supplier credit as a source. As a practical question, you still havean estimation problem on your hand when forecasting working capitalrequirements for a firm that has negative non-cash working capital. As in theprevious scenario, with negative changes in non-cash working capital, there isno reason why firms cannot continue to use supplier credit as a source ofcapital in the short term. In the long term, however, we should not assume thatnon-cash working capital will become more and more negative over time. At somepoint in time in the future, you have to either assume that the change innon-cash working capital is zero or that pressure will build for increases inworking capital (and negative cash flows)

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