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.
- We will
back out cash and investments in marketable securities from current
assets. This is because cash, especially in large amounts, is invested by
firms in treasury bills, short term government securities or commercial
paper. While the return on these investments may be lower than what the
firm may make on its real investments, they represent a fair return for
riskless investments. Unlike inventory, accounts receivable and other
current assets, cash then earns a fair return and should not be included
in measures of working capital. Are there exceptions to this rule? When
valuing a firm that has to maintain a large cash balance for day-to-day
operations or a firm that operates in a market in a poorly developed
banking system, you could consider the cash needed for operations as a
part of working capital.
- We will
also back out all interest bearing debt Š short term debt and the portion
of long term debt that is due in the current period Š from the current
liabilities. This debt will be considered when computing cost of capital
and it would be inappropriate to count it twice.
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
|
|
1999 |
2000 |
|
Cash
& Near Cash |
282 |
301 |
|
Marketable
Securities |
204 |
386 |
|
Trade
Debtors (Accounts Receivable) |
1980 |
2186 |
|
Stocks
(Inventory) |
515 |
475 |
|
Other
Current Assets |
271 |
281 |
|
Total
Current Assets |
3252 |
3629 |
|
Non-Cash
Current Assets |
2766 |
2942 |
|
|
|
|
|
Trade
Creditors (Accounts Payable) |
215 |
219 |
|
Short
Term Debt |
913 |
1169 |
|
Other
Short Term Liabilities |
903 |
774 |
|
Total
Current Liabilities |
2031 |
2162 |
|
Non-debt
current liabilities |
1118 |
993 |
|
|
|
|
|
Working
Capital |
1221 |
1467 |
|
Non-cash
Working Capital |
1648 |
1949 |
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
|
|
1999 |
2000 |
Change |
|
Inventory |
$1,462 |
$1,904 |
$442 |
|
Other
non-cash CA |
$285 |
$335 |
$50 |
|
|
|
|
|
|
Accounts
Payable |
$806 |
$1,067 |
$261 |
|
Other
non-interest bearing CL |
$778 |
$702 |
-$76 |
|
|
|
|
|
|
Non-cash
Working Capital |
$163 |
$470 |
$307 |
|
Revenues |
$11,635 |
$13,673 |
$2,038 |
|
Working
capital as % of revenues |
1.40% |
3.44% |
15.06% |
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.
- One is to
use the change in non-cash working capital from the year ($307 million)
and to grow that change at the same rate as earnings are expected to grow
in the future. This is probably the least desirable option because changes
in non-cash working capital from year to year are extremely volatile and
last yearÕs change may in fact be an outlier.
- The
second is to base our changes on non-cash working capital as a percent of
revenues in the most recent year and expected revenue growth in future
years. In the case of the Gap, that would indicate that non-cash working
capital changes in future years will be 3.44% of revenue changes in that
year. This is a much better option than the first one, but the non-cash
working capital as a percent of revenues can also change from one year to
the next.
- The third
is to base our changes on the marginal non-cash working capital as a
percent of revenues in the most recent year, computed by dividing the
change in non-cash working capital in the most recent year into the change
in revenues in the most recent year, and expected revenue growth in future
years. In the case of the Gap, this would lead to non-cash working capital
changes being 15.06% of revenues in future periods. This approach is best
used for firms whose business is changing and where growth is occurring in
areas different from the past. For instance, a brick and mortar retailer
that is growing mostly online may have a very different marginal working
capital requirement than the total.
- The
fourth is to base our changes on the non-cash working capital as a percent
of revenues over a historical period. For instance, non-cash working capital
as a percent of revenues between 1997 and 2000 averaged out to 4.5% of
revenues. The advantage of this approach is that it smoothes out year to
year shifts, but it may not be appropriate if there is a trend (upwards or
downwards) in working capital.
- The final
approach is to ignore the working capital history of the firm and to base
the projections on the industry average for non-cash working capital as a
percent of revenues. This approach is most appropriate when a firmÕs
history reveals a working capital that is volatile and unpredictable. It
is also the best way of estimating non-cash working capital for very small
firms that may see economies of scale as they grow. While these conditions
do not apply for the Gap, we can still estimate non-cash working capital
requirements using the average non-cash working capital as a percent of
revenues for specialty retailers of 7.54%.
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
|
|
Current |
1 |
2 |
3 |
4 |
5 |
|
Revenues |
$13,673.00 |
$15,040.30 |
$16,544.33 |
$18,198.76 |
$20,018.64 |
$22,020.50 |
|
Change in revenues |
|
$1,367.30 |
$1,504.03 |
$1,654.43 |
$1,819.88 |
$2,001.86 |
|
1. Change in non-cash WC |
$307.00 |
$337.70 |
$371.47 |
$408.62 |
$449.48 |
$494.43 |
|
2. Current: WC/ Revenues |
3.44% |
$47.00 |
$51.70 |
$56.87 |
$62.56 |
$68.81 |
|
3. Marginal: WC/ Revenues |
15.06% |
$205.97 |
$226.56 |
$249.22 |
$274.14 |
$301.56 |
|
4. Historical Average |
4.50% |
$61.53 |
$67.68 |
$74.45 |
$81.89 |
$90.08 |
|
5. Industry average |
7.54% |
$103.09 |
$113.40 |
$124.74 |
$137.22 |
$150.94 |
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
|
Year |
Current |
1 |
2 |
3 |
4 |
5 |
|
Revenues |
$1,000.00 |
$1,100.00 |
$1,210.00 |
$1,331.00 |
$1,464.10 |
$1,610.51 |
|
Non-Cash
WC as % of Revenues |
10% |
9% |
8% |
7% |
6% |
6% |
|
Non-cash
Working Capital |
$100.00 |
$99.00 |
$96.80 |
$93.17 |
$87.85 |
$96.63 |
|
Change in
Non-cash WC |
|
-$1.00 |
-$2.20 |
-$3.63 |
-$5.32 |
$8.78 |
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)