Business Valuation: Excluding Cash For Changes in Net Working Capital

Business Valuation: Excluding Cash For Changes in Net Working Capital

There are many reasons for a client to need to determine the value of a company. Revenue Ruling 59-60 is the impetus for all business valuations (appraisals). There are three approaches that are utilized to value a business. The three approaches are the Asset-Based Approach, Income Approach and the Market Approach. Underneath each approach there are many business valuation methods that can be used to determine the value of a company. The Discounted Cash Flow is generally considered the preferred methodology for all cash flow-generating assets in preparing a business valuation. As with all business valuation models, there are subjective assumptions that need to be made. This requires years of experience to determine the reasonableness of the various assumptions being made by the business valuation expert.

Income Approach

Two of the methods that are included in the Income Approach are the Capitalized Cash Flows and the Discounted Cash Flows. Both of these methods are used to project/forecast the value of a company based on its cash flows.

Capitalized Cash Flows

The Capitalization of Cash Flows normalizes the financial statement data and determines if the cash flows are stabilized. If they are not stabilized, this method should not be used.

Discounted Cash Flows

The Discounted Cash Flow also normalizes the historical financial statement data and makes projections/forecasts on data that is not stabilized and/or has unusual expectations for future operations. (i.e. COVID)

Changes in Net Working Capital

Net Working capital has two definitions. One is an accounting and the other is a business valuation definition. The accounting world looks at working capital as the total current assets less the total current liabilities. Any accounting course at any university will drill this into all future Certified Public Accountants (“CPA”) heads. This is what creates errors in the business valuation world.

The second definition applies to the business valuation world. This definition excludes cash in the change in net working capital definition. The cash is excluded because as we are attempting to determine the value of a company based on the risk of receiving cash. Since there is no risk of receiving the cash on hand, it is excluded.

Identifying the Inclusion or Exclusion of Cash

When the business valuation is prepared, there should be sufficient supportable information to understand how the business valuation expert reached their conclusion of value.  The attorney should be able to locate the change in net working capital analysis in the report. If cash has been eliminated, the cash is being handled correctly from a business valuation standpoint. If the cash is still included in the change in net working capital, this will make the conclusion of value incorrect.

Impact on Value

On a valuation I was recently working on and I removed the adjustment for cash. The value of the company was approximately 1,300,000 with the removal of cash. I added back the cash and obviously had a different value. In this case, it made a 37% difference in the value of the company. As you can see, it is very easy to manipulate the value of a company.

Business Valuation: Excluding Cash For Changes in Net Working Capital

The chances of the business valuation expert to prepare a schedule for something they will not use is none and none. Therefore the exclusion of cash will not be in their analysis.

Questions: Ask the expert if they excluded cash in the change in Net working capital analysis.

Answer:

No. Then the analysis and all calculations dependent on the changes in net Working Capital are incorrect.

Yes: Ask to see the removal of cash adjustment in their working papers. We are not in the trust business.

If the cash has been removed, the theory is correct.

What's Next?

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