When a business is being valued, sometimes working capital can be overlooked. It is important to remember, however, as it can have a material effect on value. Working capital is defined as the difference between a business’ current assets and current liabilities.
If an appraiser is using the income or market approach to determine a company’s value, they will add back any excess working capital to the value estimate. If the company lacks working capital, the appraiser should show a reduction in cash flows to reflect the deficit.
How Excess (or Deficit) Working Capital is Determined
A company that has a ratio of one current asset for every current liability is liquid enough to cover its short term obligations. Businesses may strive for a larger ratio, but what’s ideal varies from company to company and industry to industry. Analysis and professional judgment are required to decide what working capital levels are required for a particular business.
A helpful way to look at it is to compare working capital to that of similar businesses in the same field. If the subject company’s current ratio is significantly higher or lower than the ratios of similar companies, more analysis will be required. An appraiser will probably review of each category of assets and liabilities included in working capital to gain insight into the nature of the ratio.
An example might be if a company had a high amount of accounts receivable, indicating that it is not managing collections efficiently. A would-be buyer would have to consider the likelihood of turning those accounts receivable into cash. Higher-than-average working capital balances that are easy to convert into cash are strong indicators of excess working capital.
The Bardahl Formula
Another consideration might be whether the company needs more working capital in order to effectively operate. It can take more than a single look at assets. An important Tax Court case (Bardahl Manufacturing v. Commissioner, T.C. Memo 1965-200) suggests studying the subject company’s entire business cycle to fully unterstand its unique working capital needs.
Under the Bardahl formula, a business’ working capital needs are computed by figuring out the length of its operating cycle and the amount of working capital needed to operate a business for that whole cycle. Originally this was assumed to be an annual cycle, but that might not be true for every company. A seasonal business, for instance, might want to use its peak time of year, rather than an annual average.
Crunching the Numbers
After the valuator has assessed the business’ working capital need, they can then compare it to the working capital on the valuation date. If it is greater on that date, it will be added to the value estimate, just as any shortfalls would reduce the value estimate.
If appropriate working capital levels and needs are not properly analyzed, a business’ value can be either under- or over-stated. Contact Filler & Associates for more information on this potential valuation element.