In a business valuation income approach, the income stream being capitalized (in a capitalized income method) or discounted (in a discounted income method) is often the free cash flow generated by the entity being valued. Free cash flow is typically calculated on an after-tax basis, and represents the cash available to a company’s owners after allowing for sufficient reinvestments of cash to maintain the company as a going concern and provide for future growth.
Most free cash flow forecasts used in a business valuation assume that the business being valued will remain in business and continue to grow. Since ongoing investments in accounts receivable, inventory and fixed assets are typically essential to the continued operations of a business, it is common to adjust free cash flow forecasts to reflect working capital changes. Working capital is defined as current assets minus current liabilities, and for this blog we are assuming that the subject company utilizes an accrual basis of accounting. From a simplified standpoint, working capital reflects current assets (such as new inventory) that are not financed by trade creditors (represented by accounts payable) for which the Company must obtain cash to acquire.
Working capital consists of the current assets and current liabilities that a company requires to operate on a daily basis. These accounts can include:
- Accounts receivable
- Other current assets
- Accounts payable
- Accrued expenses
- Short term notes payable
- Other current liabilities
In a detailed forecast of working capital, the change in each of these accounts is typically driven by the change in a related account or accounts – deemed Forecast Drivers:
|Component of Working Capital||Typical Forecast Drivers|
|Inventory||Cost of Goods Sold (COGS)|
|Other current assets||Depends on what accounts are included in this category. Look at descriptions and historical trends.|
|Accounts payable||Inventory or COGS|
|Accrued expenses||Often tied to COGS or General and Administrative (G&A) expenses.|
|Short term notes payable||Can be tied to loan amortization schedules or to levels of assets financed such as inventory.|
|Other current liabilities||Depends on what accounts are included in this category.|
The historical relationship of each of the current assets and current liabilities to the relevant underlying Forecast Driver is typically determined by a rigorous financial analysis of the company’s operations over time.
The faster a company grows and expands, the more cash it will need. During times of growth, companies accumulate additional accounts receivable and inventory at levels that exceed trade financing, requiring additional cash investments. Increased working capital investments impact free cash flow forecasts in ways including:
- If current assets increase, all else held constant:
- Working capital can increase
- Free cash flow can decrease
- If current liabilities increase, all else held constant:
- Working capital can decrease
- Free cash flow can increase
- If increases in current assets exceed increases in current liabilities:
- Working capital increases
- Free cash flow decreases
Under ordinary operating conditions, many, if not most, companies have positive working capital (current assets exceed current liabilities), so forecasted increases in revenues require additional working capital investments, and free cash flow is reduced, all else held constant. It is also possible for a company to have negative working capital (current liabilities exceed current assets) under ordinary operating conditions, such as hotels or airlines that are fixed asset intensive companies with limited inventories and immediately collect payments for services from charge cards. A company in such an industry often reflects a growing negative working capital balance, which effectively can be a source of free cash flow for that company.
A negative change in working capital (working capital forecast to decrease) is also possible in certain businesses and at certain times, such as when a business is experiencing a downturn in its markets. The implications of this assumption in a long-term forecast must be carefully analyzed. While a company may forecast selling off excess inventory or tightening its credit policies, for example, reducing working capital and increasing free cash flow, these sources of cash are not reasonably sustainable over the long-term. At some point, working capital excesses will be eliminated and further reductions in working capital can hamper revenue growth or even the viability of a company.
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