Working Capital Changes in a Free Cash Flow Forecast– Part II

Kelly Schmid
Director of Valuation Services
March 7, 2018

Part I of my working capital related blog addressed the impact on free cash flow of changes in current assets and changes in current liabilities, which are the two components that comprise working capital (calculated as current assets minus current liabilities). The combined impact of changes in current assets and changes in current liabilities equals the impact of changes in working capital on free cash flow. Part II of this blog identifies methods often used by business appraisers when forecasting working capital.

At the core, working capital changes are analyzed and projected to ensure changes in cash are correctly forecast. Merely because a company produces a net profit of $100,000 does not mean the company has $100,000 in cash available to distribute to its owners.

The ratio of sales method is commonly used to forecast the impact of working capital changes on free cash flow in a business valuation where the subject company utilizes the accrual basis of accounting.  This method is readily understandable and can reflect these variations:

  • Use the change (in currency) in working capital from the two years before the valuation date and grow working capital at the expected sales growth rate.
  • Use the ratio of working capital to sales reflected in the year prior to the valuation date to forecast working capital levels needed to support forecast sales levels.
  • Use the ratio of working capital to sales based on a historical multi-year period using a simple average, a weighted average or a median. While this method can smooth out year-to-year changes and allow a complete business cycle to be included, it may not be appropriate for companies exhibiting a consistent downward or upward trend in working capital in the years preceding the valuation date.
  • Forecast working capital using industry average ratios of working capital to sales. This method may be useful when a company has volatile historical working capital and/or is a start-up or in high-growth mode, for example, and the analyst is not comfortable making a forecast based on the company’s historical working capital levels.

Two key caveats are in order. Under the first three methods, the inherent assumption in applying historical average working capital levels is that the historical levels reflect expected future working capital levels. Since a business valuation should reflect expected future cash flows, expected variations between historical and future working capital levels must be considered. Second, if a non-controlling interest is being appraised, the assumption that the company’s working capital levels will be changed to industry averages might not be reasonable if the company rarely reflects industry-average working capital levels and the interest being appraised does not have the unilateral power to compel changes at the company.

Other considerations include:

  • The company’s historical working capital ratios and industry working capital metrics
  • Historical and industry normal metrics of the individual components of working capital (e.g., accounts receivable, inventory, accounts payable, etc.)
  • Comparability of companies in the industry group to the operations of the subject company when the subject’s metrics exhibit a large variance from the industry
    • In the case of very small companies, historical ratios may be more relevant
    • For larger companies that appear to be comparable, further analysis may still be necessary

My next blog will present additional thoughts on forecasting working capital.

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