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:
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:
My next blog will present additional thoughts on forecasting working capital.
If you are interested in learning more about how you can strengthen your case with a business valuation expert or want to learn more about our services and our team, please contact us.