How does working capital impact the value of my business?

A primary principle of valuation, particularly in going concern valuation, is that working capital is included in the business. Working capital is often a contentious topic during a transaction, as the seller and buyer will often have differing views on what the business requires. Generally, working capital also lends itself to misinterpretations. Ultimately, working capital will fall into one of three categories:

• Enough
• Surplus
• Poor

The real question is: how much working capital is required for this business to continue operating as it is now and follow the indicated growth trajectory? What is the level of working capital that is proportional to profit?

Working capital levels are assessed to determine where a business stands. Working capital levels are measured based on industry norms, typical bank settlement ratios, percentage of forecast sales, and requirements based on financial and operating forecasts.

Working capital levels are assessed to determine where a business stands. Working capital levels are measured based on industry norms, typical bank settlement ratios, percentage of forecast sales, and requirements based on financial and operating forecasts.

How much is enough or not enough?

Sufficient working capital levels are typically shown as amounts that have been consistently retained in the business, year after year, while allowing for distributions to shareholders for bonuses or dividends that have not been required to be re-lent to the business as loans. of shareholders. What this means is that often a business owner receives an annual shareholder bonus to reduce the taxable income of the business, the business pays the tax on the lower income, the shareholder pays the tax on the income received and then the shareholder lends the money to the business to finance operations, and this often happens year after year.

This is an example of a shareholder financing the ongoing operations of a business and shows that the shareholder’s loan capital is necessary for the ongoing operations of the business.

Poor working capital levels are characterized in two ways.

• The first is where there are more current liabilities than current assets and the company will have ongoing difficulties meeting its obligations.
• The second, and less obvious, is when a business still has a positive working capital balance, but the amount of working capital is insufficient to launch new initiatives, support growth, and generally require the business to adopt the status quo.

What is considered an excess working capital position and how can it be accounted for?

Adequate working capital is the working capital to operate the business in a sustained state, without considering growth. If the EBITDA being used in a multiple approach incorporates forecast growth in EBITDA, then the amount of working capital must be sufficient to handle the growth profile which would be a higher requirement and may reduce the perceived working capital surplus. .

Every business is different and some of the elements that must be considered in determining the surplus or deficiency of working capital are the following:

• Comparison with industry norms for top performing companies
• Indices of income to working capital
• seasonality
• Growth capital expenditure requirements
• Inventory turns
• Account receivable days
• A/P days
• Maximum amount of operating line of credit or cash available
• Whether excess working capital is used to obtain purchase discounts

What should companies be doing in this area?

When a business is valued, to prepare for sale or for another purpose, an analyst will use various techniques to analyze the working capital needed to keep a business operating at normal levels. If a business has “excess working capital,” the excess amount is considered additional value and is classified as a non-operating asset. If the company is deemed to have insufficient working capital, the value of the company will be adjusted lower to make up the shortfall to the acceptable level of working capital.

As a function and indication of the company’s operating cycle and its ability to break even during the cycle. A general rule of thumb, for most non-seasonal industries, is that a business should be able to finance three (3) months of its expenses using its current assets.

A correct and appropriate management of working capital can maximize the value of any company. Our corporate finance department is well versed in providing specialized M&A finance solutions.

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