Working Capital: A Potential Valuation Sleeper

by | Jul 3, 2020 | Cash Flow

Working capital is sometimes overlooked in determining the value of a business. But it can have a material effect on value, so it’s important to remember. A business’s working capital equals the difference between its current assets and current liabilities.

When the value of a business is determined under either the income or the market approach, the appraiser will add back any excess working capital to the preliminary value estimate. Alternately, when the company lacks sufficient working capital, the analyst should make an adjustment to reflect either a liability for deficit working capital or a reduction in cash flows for the input of additional working capital.

How to Determine Excess (or Deficit) Working Capital

A current ratio of one current asset for every current liability means that the company is “liquid” enough to cover its short term obligations. Many businesses strive for a 2:1 current ratio — but what’s typical or ideal varies from company to company and industry to industry. Deciding what working capital levels are required for the operations of a particular business requires some analysis and professional judgment.

A useful starting point is to compare the subject company’s working capital to the working capital of similar companies in the same industry and of comparable size. If the subject company’s current ratio is significantly higher than the ratios of similar companies, the valuator will evaluate the reasons for the higher ratio to determine whether the company has excess working capital. A review of each category of assets and liabilities included in working capital provides some insight into the nature of the ratio.

For example, the subject company might have a high level of accounts receivable, because it’s managing collections inefficiently. In fact, some older receivables may even need to be written off as bad debts. A hypothetical buyer would evaluate the likelihood of converting each current asset balance into cash. Higher-than-average working capital balances that are easy to convert into cash are strong indicators of excess working capital.

The Bardahl Formula

Valuators also consider whether the business needs a higher level of working capital than others to run its operation. A peripheral look at the current ratio or working capital as a percentage of total assets can be misleading, however. A prominent Tax Court case (Bardahl Manufacturing v. Commissioner, T.C. Memo 1965-200) suggests analyzing the subject company’s business cycle to estimate its unique working capital needs.

Under the Bardahl formula, the working capital needs of a business are computed by determining the length of its operating cycle and the amount of working capital needed to operate a business for that cycle. The original Bardahl formula assumes that working capital needs are computed using annual figures. However, this may not be appropriate in every case. A seasonal business — such as a construction firm — with working capital needs that fluctuate throughout the year may prefer to use its maximum or peak cycle, rather than a cycle that applies a 12-month average.

Crunching the Numbers

After analyzing the subject company’s working capital needs, the valuator can compare its needs to its working capital balance on the valuation date. Any working capital beyond its expected needs is generally added to the preliminary value estimate determined under the income or market approach to determine the fair market value of the subject company. Conversely, any shortfalls will reduce the preliminary value estimate.

Failure to properly analyze the actual working capital levels and probable working capital needs of the subject company can lead to either an understatement or overstatement of the value of the subject company. Contact a valuation professional for more information on this potential valuation “sleeper” element.