Working capital in valuation

Working capital is usually defined to be the difference between current assets and current liabilities. However, we will modify that definition when we measure working capital for valuation purposes.

Will these changes increase or decrease working capital needs? The answer will vary across firms.

            The non-cash working capital varies widely across firms in different sectors and often across firms in the same sector. Figure 10.2 shows the distribution of non-cash working capital as a percent of revenues for U.S. firms in January 2001.


Illustration 10.7: Working Capital versus Non-cash Working Capital Š Marks and Spencer

            Marks and Spencer operates retails stores in the UK and has substantial holdings in retail firms in other parts of the world. In Table 10.9, we break down the components of working capital for the firm for 1999 and 2000 and report both the total working capital and non-cash working capital in each year:

Table 10.9: Working Capital versus Non-cash Working Capital: Marks and Spencer




Cash & Near Cash



Marketable Securities



Trade Debtors (Accounts Receivable)



Stocks (Inventory)



Other Current Assets



Total Current Assets



Non-Cash Current Assets






Trade Creditors (Accounts Payable)



Short Term Debt



Other Short Term Liabilities



Total Current Liabilities



Non-debt current liabilities






Working Capital



Non-cash Working Capital



The non-cash working capital is substantially higher than the working capital in both years. We would suggest that the non-cash working capital is a much better measure of cash tied up in working capital.

Estimating Expected Changes in non-cash Working Capital

While we can estimate the non-cash working capital change fairly simply for any year using financial statements, this estimate has to be used with caution. Changes in non-cash working capital are unstable, with big increases in some years followed by big decreases in the following years. To ensure that the projections are not the result of an unusual base year, you should tie the changes in working capital to expected changes in revenues or costs of goods sold at the firm over time. The non-cash working capital as a percent of revenues can be used, in conjunction with expected revenue changes each period, to estimate projected changes in non-cash working capital over time. You can obtain the non-cash working capital as a percent of revenues by looking at the firmÕs history or at industry standards.

Should you break working capital down into more detail? In other words, is there a payoff to estimating individual items such as accounts receivable, inventory and accounts payable separately? The answer will depend upon both the firm being analyzed and how far into the future working capital is being projected. For firms where inventory and accounts receivable behave in very different ways as revenues grow, it clearly makes sense to break down into detail. The cost, of course, is that it increases the number of inputs needed to value a firm. In addition, the payoff to breaking working capital down into individual items will become smaller as we go further into the future. For most firms, estimating a composite number for non-cash working capital is easier to do and often more accurate than breaking it down into more detail.

Illustration 10.8: Estimating Non-cash Working Capital Needs Š The Gap

            As a specialty retailer, the Gap has substantial inventory and working capital needs. At the end of the 2000 financial year (which concluded January 2001), the Gap reported $1,904 million in inventory and $335 million in other non-cash current assets. At the same time, the accounts payable amounted to $1,067 million and other non-interest bearing current liabilities of $702 million. The non-cash working capital for the Gap in January 2001 can be estimated.

Non-cash working capital = $1,904 + $335 - $1067 - $ 702 = $470 million

In Table 10.10, we report on the non-cash working capital at the end of the previous year and the total revenues in each year:

Table 10.10: Working Capital Š The Gap









Other non-cash CA








Accounts Payable




Other non-interest bearing CL








Non-cash Working Capital








Working capital as % of revenues





The non-cash working capital increased by $307 million from last year to this year. When forecasting the non-cash working capital needs for the Gap, we have several choices.

To illustrate how much of a change each of these assumptions can have on working capital requirements, Table 10.11 forecasts expected changes in non-cash working capital using each of the approaches. In making these estimates, we have assumed a 10% growth rate in revenues and earnings for the Gap for the next 5 years.

Table 10.11: Forecasted Working Capital Changes: The Gap















Change in revenues







1. Change in non-cash WC







2. Current: WC/ Revenues







3. Marginal: WC/ Revenues







4. Historical Average







5. Industry average







The non-cash working capital investment varies widely across the five approaches that we have described here.

Negative Working Capital (or changes)

            Can the change in non-cash working capital be negative? The answer is clearly yes. Consider, though, the implications of such a change. When non-cash working capital decreases, it releases tied-up cash and increases the cash flow of the firm. If a firm has bloated inventory or gives out credit too easily, managing one or both components more efficiently can reduce working capital and be a source of positive cash flows into the immediate future Š 3, 4 or even 5 years. The question, however, becomes whether it can be a source of cash flows for longer than that. At some point in time, there will be no more inefficiencies left in the system and any further decreases in working capital can have negative consequences for revenue growth and profits. Therefore, we would suggest that for firms with positive working capital, decreases in working capital are feasible only for short periods. In fact, we would recommend that once working capital is being managed efficiently, the working capital changes from year to year be estimated using working capital as a percent of revenues. For example, consider a firm that has non-cash working capital that represent 10% of revenues and that you believe that better management of working capital could reduce this to 6% of revenues. You could allow working capital to decline each year for the next 4 years from 10% to 6% and, once this adjustment is made, begin estimating the working capital requirement each year as 6% of additional revenues. Table 10.12 provides estimates of the change in non-cash working capital on this firm, assuming that current revenues are $1 billion and that revenues are expected to grow 10% a year for the next 5 years.

Table 10.12: Changing Working Capital Ratios and Cashflow Effects















Non-Cash WC as % of Revenues







Non-cash Working Capital







Change in Non-cash WC








            Can working capital itself be negative? Again, the answer is yes. Firms whose current liabilities that exceed non-cash current assets have negative non-cash working capital. This is a thornier issue that negative changes in working capital. A firm that has a negative working capital is, in a sense, using supplier credit as a source of capital, especially if the working capital becomes larger as the firm becomes larger. A number of firms, with Walmart and Dell being the most prominent examples, have used this strategy to grow. While this may seem like a cost-efficient strategy, there are potential downsides. The first is that supplier credit is generally not really free. To the extent that delaying paying supplier bills may lead to the loss of cash discounts and other price breaks, firms are paying for the privilege. Thus, a firm that decides to adopt this strategy will have to compare the costs of this capital to more traditional forms of borrowing. The second is that a negative non-cash working capital has generally been viewed both by accountants and ratings agencies as a source of default risk. To the extent that a firmÕs rating drops and interest rates paid by the firm increase, there may be costs created for other capital by using supplier credit as a source. As a practical question, you still have an estimation problem on your hand when forecasting working capital requirements for a firm that has negative non-cash working capital. As in the previous scenario, with negative changes in non-cash working capital, there is no reason why firms cannot continue to use supplier credit as a source of capital in the short term. In the long term, however, we should not assume that non-cash working capital will become more and more negative over time. At some point in time in the future, you have to either assume that the change in non-cash working capital is zero or that pressure will build for increases in working capital (and negative cash flows)