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:
- Payment strategy – As a source of cash flow, a company may negotiate longer payment periods with suppliers (typically a positive) or delay payments to suppliers (can be a negative, indicating questionable liquidity). Reducing the payment period has the opposite effect and reduces cash flow.
- Collection strategy – A company may tighten the terms of payments offered to credit customers or become more aggressive in its collection policies, which reduces accounts receivable and increases cash flow. However, tighter credit policies may cause loss of customers. Loosening credit terms and/or less aggressive collection policies increases accounts receivable and reduces cash flow, but may gain additional customers who desire longer payment terms.
- Inventory management strategy – A company may increase its inventory levels to improve fulfillment rates (which initially decreases cash flow, all else held constant) or may reduce inventory levels to reduce holding costs (which initially increases cash flow, all else held constant). However, reducing inventory levels beyond a certain point may increase stockouts, which can lead longer-term to declining sales and/or a reduced sales growth rate.
- Purchasing strategy – A company may negotiate discounts for paying more quickly, or it may receive reduced prices for purchasing larger volumes, both of which initially lower cash flow, all else held constant.
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.
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