Net Working Capital and its Impact on Valuation
Understanding how it impacts the value of an organization
Most business owners understand the concept of an earnings multiple or and income-based approach to valuing their operating company. As a valuation expert, many of the questions asked when reviewing the report involve the concept of net working capital (NWC). In this two-part article, we will discuss the concept of net working capital and how it impacts the value of a company and how target net working capital calculations impact the closing of a transaction upon the sale of a business.
What is NWC?
NWC is defined as, in its most basic form, current assets minus current liabilities. However, in the real world, transactions occurring between a buyer and a seller exclude cash and debt from this equation. It is important to understand that a buyer of a company expects the seller to deliver a balance sheet that is free from debt and cash but includes normal levels of working capital. Cash and debt are removed from the equation because buyers don’t like to “purchase” cash and buyers don’t want to be beholden to existing lenders/debt holders. Therefore, many analysts will describe their analysis of net working capital as a “cash-free, debt-free” basis.
Why is analyzing NWC important?
NWC is a function and indication of the company’s operating cycle and its ability to cover expenses over the cycle. A general rule of thumb, for most non-seasonal industries, is that a company should be able to fund three (3) months of its expenses using its current assets. As part of analyzing working capital, an analyst should be able to observe the subject company’s operating cycles for its collection of receivables and payment of payables.
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