Part II of my working capital blog identified methods often used by business appraisers when forecasting working capital. In this installment, I will present some additional thoughts regarding this topic.
Depending on the facts and circumstances, it is typically appropriate to consider the company’s historical working capital ratios and industry working capital metrics at the composite level (e.g. total working capital), as well as each separate component of working capital (e.g. accounts receivable, inventory, accounts payable, etc.). If the company’s metrics exhibit a large variance from the industry, the comparability of the companies in the industry group to the operations of the company being valued should be analyzed. If the subject company is not comparable, its historical ratios are more relevant for valuation purposes (this is often the case for very small companies, particularly depending upon how they choose to capitalize themselves). For larger companies that appear to be comparable to those included in the measurement of industry data, further analysis may still be necessary. For example, if the analysis of the company’s financial ratios show that the company’s speed of collections is slowing in relation to its historical collection ratio or in comparison to the industry, the individual components of the working capital change may need to be looked at separately.
Other items that may be implicit in a company’s working capital forecast and require a conversation with company management include:
Overall, in the context of cash flow forecasting for business valuation purposes (as opposed to forecasting for capital or operating budgeting purposes), estimating a change in overall working capital is definitely simpler to do, as it avoids the detailed analysis necessary to forecast a number of inputs and may be reasonably accurate. However, the assumptions imbedded in each working capital component that comprise the overall change in working capital still often need to be considered.
The level of working capital has a direct influence on the value of a company. Tying up cash in excess working capital may cause cash flow and profits to suffer. Insufficient working capital reduces a company’s liquidity, potentially increasing a company’s risk and the cost of obtaining capital, thereby potentially reducing its value.
In my next installment – Part IV – I will address forecasting working capital changes for a company that uses a cash basis of accounting.
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