What is the role of working capital in a business valuation? Pretend that your company is having a business valuation prepared for estate planning purposes and you have excess working capital in your company. Will the value of your company be higher if there is excess working capital included in your business? The answer is yes. The opposite is true, as well, if your company has a deficiency in working capital, then the value of your company will be reduced for that deficiency.
What is Working Capital?
Working capital is generally defined as the difference between current assets and current liabilities. (There are some variations in how working capital is calculated, such as whether or not to include the short-term portion of long-term debt.) Every company has a certain level of working capital that is necessary for operations; working capital above the amount needed for operations is considered excess. Since excess working capital is not necessary to maintain operations, it is added to the value of operations as calculated under the income and market approaches to valuation. (It should be noted that if there are any earnings related to excess working capital such as investment income on investments, these earnings should be removed from the earnings amount used to value operations so that the value of this asset is not double-counted.)
What is a Deficency in Working Capital?
On the other hand, if a company does not have sufficient working capital necessary to support operations, then that company has a deficiency in working capital. A working capital deficiency is considered a liability for valuation purposes. The liability for a working capital deficiency reduces the value of operations as calculated under the income and market approaches to valuation.
Determining whether or not a company has an excess or deficiency in working capital is subjective. In the third edition of Financial Valuation: Applications and Models, James Hitchner states that, “Excess working capital can be identified by comparing the working capital ratio of the subject company to those of the guideline companies or by comparisons to industry norms.” [i] There are certain measures such as industry averages for working capital as a percentage of sales or the current ratio (current assets divided by current liabilities) that can provide an industry benchmark. Your company’s ratios can be compared to these industry benchmarks in order to provide an indication of whether or not there is an excess or deficiency in working capital. Other qualitative and quantitative factors might be considered as well, such as knowing the required working capital needed to support expenses.
If it has been determined that there is excess working capital in your business, then the value of your company might be increased to account for that excess. Furthermore, if there is a deficiency of working capital, then the value of your business may be decreased to account for that deficiency.
[i] Hitchner, James R., Financial Valuation: Applications and Models. 3rd ed. Hoboken, New Jersey: John Wiley & Sons, Inc., 2011.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.