Two of the most fundamental concept of financial analysis is cash flow and working capital. Cash flow is mainly associated with a cash flow statement of the companies financial statement. Working capital, on the other hand, is mostly associated with the balance sheet. Various sections of a financial statement affect each other. And the change in working capital affects the company’s cash flow.
This is also referred to as net working capital, it is the difference between the current assets, accounts receivable, and inventories of the raw materials and the finished goods of a company. It is also a measure of the company’s operation efficiency, liquidity, and short term financial health. In most cases, these calculations are similar, derived from the company’s less account payable, cash plus accounts, receivable plus inventories, and less accrued expenses.
So, if a company has a substantial positive working capital, then it has the potential of investing and growing. If the current assets of the company don’t exceed the current liabilities, then there will be trouble in growing or paying back the creditors. It may even go bankrupt.
. If the current ratio of assets to liabilities is below one, then the company has negative capital.
. Positive working capital means the companies are capable of funding the current operations and also invest in future growth and activities.
. High working capital is not always a good thing. That is because it can indicate that the business isn’t investing the excess cash or it has too much much inventory.
Cash flow. This is the net amount of cash and cash equivalents that gets transferred in and out of the company. Positive cash flow means the liquid assets of a company are increasing. Meaning it will be able to reinvest in its business, settle debts, pay expenses, provide the buffer against future financial challenges and also return money to the shareholders.
. Cash flows are available in three forms. That is operating, investing, and financing.
. Operating cash flow consists of all cash generated by the main business activities of the company.
. Investing cash flow consists of all purchases of investments and capital assets in other business ventures.
. Financing cash flow includes the proceeds gained from the issuing debt and equity and the payments made by the company.
Free cash flow is a measure used by analysts while assessing the company’s profitability, represents the cash generated by a company after it accounts for cash outflows used to support operations and also maintain its capital assets.
The working capital of a company is the main part of funding its daily operations. It is an essential component of the exit strategy. However, working capital is overlooked when looking at a potential transaction.
Most buyers/sellers sometimes don’t understand the effects of working capital on cash flow. Assets are hard to value, and liabilities may be missed because they may be unseen on the balance sheet. Buyers will want to maintain much liquidity after the deal while sellers are interested in pulling out more cash before the deal closes.
Analysts use these three methods in determining the company’s value. That is the income approach, market approach, and asset approach. The income approach methods normally consider future cash flows. The market approach, on the other hand, considers the selling price of other similar companies while the asset approach focuses on the company’s assets and liabilities.
How does working capital impact the deal terms?
It is vital for the buyer and seller to negotiate on how they will treat working capital in a transaction because it is a cause of disputes. A target working capital is always the first source of conflict. Other things like the seasonality of expenses and revenue may lead to fluctuations throughout the year. It may be difficult to determine what is impacting the net working capital which will be unanticipated while moving ahead.
That is because businesses continue operating during the transaction process throughout. Therefore closing the estimated working capital will affect the buying price on The closing date.
During the first months after closing, there will be a true up phase to bring in line the net working capital balance. Ideally, true-up calculation is also a potential source of conflict which makes it the second. There may be disagreements regarding certain balance sheet accounts, methods of accounting used, their values, and the exclusion or inclusion from true-up calculations.
However, there are certain ways in which the management can maximize value thus preventing transaction problems. They can improve the efficiency of working capital use thus improving the working capital turnover ratio. The working capital turnover ratio gets calculated by dividing sales against working capital, then indicate how a company utilizes its working capital. Also, the management maintains the monthly working capital and also analyzes the historical trends. This will help them avoid any surprises and disputes during the transaction process.
Importance of working capital
Working capital levels have an impact on values making it a vital consideration while transacting. A seller can increase the company’s value by managing the working capital levels while a buyer can protect them against the deficiency of working capital with proper due diligence.
Cash flow basis method of working capital assessment.
Here are various approaches that can be used in calculating the net working capital. That may only include inventory, account receivables, and accounts payable or may exclude debt and cash. An analyst can use:
Net working capital = current assets – current liabilities
Net working capital= accounts receivables+ inventory – accounts payable
Net working capital = current assets(less cash) – current liabilities(less debt)
Method one is the broadest as it combines all accounts. The second formula tends to be the most narrow as it is limited to only three accounts whereas the third formula tends to be more narrow.
There are also three main valuation methods used by practitioners when valuing a company. That is:
. Discounted cash flow(DCF) analysis
. Comparable company analysis
. Precedent transactions
When valuing an asset or business, you can apply the following methods.
. Cost approach
It focuses on what it did cost to replace or rebuild an asset. So, when valuing your property, real estate, or investment security it is the best approach.
. Market approach
This is a form of relative valuation and is commonly used in industries. It includes comparable analysis precedent transactions.
. Discounted cash flow
Is a type of intrinsic valuation that is more detailed and has a thorough approach to valuation.