What’s the context of working capital in valuation?

In this article, we will cover what working capital means, how it affects a company’s operations, and how it should be factored into company valuations.

In the dab smack of the COVID-19 pandemic, a PwC study stated that poor working capital was the top reason for companies to pursue change management and restructuring initiatives. This figure is not just the difference between certain assets and liabilities. It represents a company’s ability to take advantage of opportunities and handle shocks to its cost structure.

By analyzing this figure, you can unlock valuable insights into your company’s operational efficiency and short-term liquidity.

Despite its importance in company valuations, this figure often lurks in the overlooked areas of balance sheets and must be brought to light to unlock the true value of a company.

In this article, we will cover what working capital means, how it affects a company’s operations, and how it should be factored into company valuations. Read on to know more!

What is working capital?

Working capital is the difference between your company’s current assets and liabilities. Short-term assets and liabilities expected to be settled within a year are called current assets and liabilities.

You can find some common examples of current assets and liabilities in the following table:

Current assetCurrent liabilities
  • Cash

  • Money market instruments and other cash equivalents

  • Accounts receivable

  • Prepaid expenses

  • Marketable securities like stocks and bonds
  • Accounts payable

  • Taxes

  • Short-term debt like credit card debt

  • Advances received for products yet to be delivered

  • Interest payable
  • How does working capital affect your company’s operations?

    Financial analysts use working capital as a measure of a company’s liquidity. Liquidity influences the smoothness of a company’s operations and how well it manages inventory levels.

    When your company has a healthy working capital, you can secure favorable terms with your suppliers as they will have a better assurance of payment. You will find it easier to negotiate longer payment schedules and low interest rates.

    Another benefit of healthy working capital is that your organization becomes resilient to unexpected expenditures and price fluctuations. If you have poor working capital, the smallest of price hikes or unexpected expenditures can make it difficult to procure raw materials. However, a company with healthy working capital can deal with much larger price hikes and unexpected expenditures.

    Let us understand this with an example of two food processing companies with different levels of working capital and book values. The key details of HarvestMate and GrainGuru, two food processing companies, are as follows:

    CharacteristicsHarvestMateGrainGuru
    Book value
    (Total assets - Total liabilities)
    $12,000,000.00$4,000,000.00
    Working capital
    (Current assets – Current liabilities)
    $1,200,000.00$500,000.00
    Quantity of wheat processed every month
    (in tons)
    24,000.008,000.00

    We also know that these companies focus only on wheat whose last trading price was $250 per ton. Suppose that the price of wheat increases by 30% due to geopolitical issues and supply chain disruptions. Let us see how this impacts the input cost of the two companies.

    ParticularsHarvestMateGrainGuru
    Input cost prior to price hike$6,000,000.00$2,000,000.00
    Input cost post-price hike
    (For the same quantity)
    $7,800,000.00$2,600,000.00
    Rise in input cost$1,800,000.00$600,000.00
    Percentage of rise in input cost that can be covered with existing working capital66.67%83.33%

    So, we see that even though HarvestMate is a much larger company, the crisis is a lot more serious for it because of its poor working capital. This becomes even more clear when we look at the expected drops in processing volume for the two companies.

    ParticularsHarvestMateGrainGuru
    Quantity of wheat processed every month prior to the price hike24,000.008,000.00
    Quantity of wheat processed every month post-price hike
    (After using up all working capital)
    22,153.857,692.31
    Drop in processing volume7.69%3.85%

    How is the impact of working capital factored into valuations?

    Working capital directly affects a company’s cash flows, the stability of operations, and reliance on short-term credit. Hence, we must incorporate its impact into company valuations in the following manner:

    Key input for income-based approach

    In the income approach, we make financial projections based on a company’s financial history and the outlook for external conditions. If external conditions are expected to become less favorable, we must adjust the cash flows accordingly. However, with healthy working capital, we can make a smaller negative adjustment in worsening external conditions.

    Conversely, healthy working capital positions the company to better exploit positive external conditions. Hence, we can make larger positive adjustments to cash flows in the years when external conditions are expected to improve.

    Working capital is also a direct input into income-based approaches like the discounted cash flow (DCF) method. After projecting financial figures for a certain period, we must calculate the free cash flow to the firm (FCFF) which must then be discounted. The formula for free cash flow to a firm is:

    Free cash flow to firm FCFF=NOPAT+D&A -Capital expenditure-Changes in working capital

    Here:

    • NOPAT = Net operating profit after tax
    • D&A = Depreciation and amortization

    Subtracting the changes in working capital will lead to a lower valuation for the company. We make these adjustments to reflect the need for higher working capital investments.

    Risk adjustments in other valuation approaches

    In the market-based valuation method, we establish a market valuation multiple based on the total valuation of similar companies and their total sales, revenue, or some other appropriate financial figure. Then, we apply this market valuation multiple to the company being valued to find its valuation. If the companies considered were not similar enough, we must make adjustments to the valuation.

    Similar adjustments must be made when we use the comparable company analysis method for valuation.

    To make these adjustments, we consider differences in geographies, company sizes, growth rates, market share, financial figures, and operational efficiency which can partly be understood through working capital efficiency.

    Valuation example

    In this example, we will see how working capital is factored into a company’s valuation through the discounted cash flow (DCF) method. We will consider Glad Rags, an apparel retailer, whose financial history is as follows:

    Particulars202220232024
    NOPAT$873,438.73$934,579.44$1,000,000.00
    Depreciation and amortization (D&A)$90,000.00$90,000.00$90,000.00
    Capital expenditure$250,000.00$ -$400,000.00

    We also know the following details about Glad Rags’ working capital.

    Particulars2024
    Current assets
    Cash and cash equivalents$343,000.00
    Accounts receivable$105,000.00
    Inventory$60,000.00
    Prepaid expenses$25,000.00
    Total current assets (A)$533,000.00
    Current liabilities
    Accounts payable$145,000.00
    Short-term debt$10,000.00
    Accrued expenses$10,000.00
    Sales tax payable$20,000.00
    Total current liabilities (B)$185,000.00
    Working capital (A-B)$348,000.00

    The company plans to expand its operations in 2027 by investing $500,000 into a new storefront. To facilitate this expansion, the company must increase its inventory by $45,000 in 2027 and its cash and cash equivalents by $30,000 in 2026.

    These investments would affect the working capital in the following manner.

    Particulars20252026202720282029
    Current assets
    Cash and cash equivalents$343,000.00$373,000.00$373,000.00$373,000.00$373,000.00
    Accounts receivable$105,000.00$105,000.00$105,000.00$105,000.00$105,000.00
    Inventory$60,000.00$60,000.00$105,000.00$105,000.00$105,000.00
    Prepaid expenses$25,000.00$25,000.00$25,000.00$25,000.00$25,000.00
    Total current assets (A)$533,000.00$563,000.00$608,000.00$608,000.00$608,000.00
    Current liabilities
    Accounts payable$145,000.00$145,000.00$145,000.00$145,000.00$145,000.00
    Short-term debt$10,000.00$10,000.00$10,000.00$10,000.00$10,000.00
    Accrued expenses$10,000.00$10,000.00$10,000.00$10,000.00$10,000.00
    Sales tax payable$20,000.00$20,000.00$20,000.00$20,000.00$20,000.00
    Total current liabilities (B)$185,000.00$185,000.00$185,000.00$185,000.00$185,000.00
    Working capital$348,000.00$378,000.00$423,000.00$423,000.00$423,000.00
    Changes in working capital$ -$30,000.00$45,000.00$ -$ -

    Other inputs for the DCF valuation analysis are:

    • Reliable financial projections can be made for 5 years
    • Depreciation and amortization (D&A) to remain constant at $90,0000
    • Discount rate = 25%
    • NOPAT is expected to grow 7% annually

    Based on this information, we can make the following projections.

    Particulars20252026202720282029
    NOPAT$1,070,000.00$1,144,900.00$1,225,043.00$1,310,796.01$1,402,551.73
    Depreciation and amortization (D&A)$90,000.00$90,000.00$90,000.00$90,000.00$90,000.00
    Capital expenditure$ -$ -$500,000.00$ -$ -
    Changes in working capital$ -$30,000.00$45,000.00$ -$ -
    Free cash flow to the firm (FCFF)$1,160,000.00$1,204,900.00$770,043.00$1,400,796.01$1,492,551.73

    We can sum the discounted FCFFs to find Glad Rags’ valuation.

    ParticularsFree cash flow to the firm
    (FCFF)
    Discounted FCFF
    2025$1,160,000.00$928,000.00
    2026$1,204,900.00$771,136.00
    2027$770,043.00$394,262.02
    2028$1,400,796.01$573,766.05
    2029$1,492,551.73$489,079.35

    Thus, we can conclude that Glad Rags’ valuation is $3,156,243.41.

    Unlock your true value with Eqvista!

    Companies must maintain a healthy working capital to maintain smooth operations, handle supply chain shocks, and exploit any available opportunities. However, in valuation analysis, this figure is not given due attention as income statement items and profit and loss statement items have a more direct effect on cash flows.

    However, this does not change the fact that working capital is a key input for income-based approaches and plays a major role in determining the risk adjustments in other valuation approaches. The insights into a company’s operational efficiency that we can gain from working capital analysis are invaluable.

    At Eqvista, we understand that accurate valuations demand attention to every detail, minute or critical. Hence, our NACVA-certified valuation analysts pride themselves on their detail-oriented approach. Allow us to unlock the true value of your company. Contact us to know more!

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