Working capital is the measure of a business’ current assets minus its current liabilities. Generally, it’s used to determine a company’s short-term financial health and efficiency in using resources. Too much working capital and it’s likely the business isn’t investing enough of its excess assets. A negative working capital signals short-term financial stress.
When using working capital in valuing a business, some adjustments to this simple definition of working capital need to be made. Working capital in valuation makes adjustments for cash and investments in short-term marketable securities because cash is usually invested into short-term interest-bearing securities or accounts. Because of this, cash should not be included in working capital when valuing a business. Also, interest-bearing short-term debt is eliminated from current liabilities, as well as the portion of long-term debt due in the current period. Essentially, these debts are used in other places during the valuation process and should not be counted twice.
The working capital in valuation equation is:
Working Capital in Valuation = Current Assets – Cash – Investments in Marketable Securities – Current Liabilities + Interest Bearing Short-Term Debt + Portion of Long-Term Debt Due in Current Period
As an example, assume a business has $100,000 of current assets and $30,000 of current liabilities. Cash on the books is $20,000 and investments in short-term marketable securities are $5,000. The company also has short-term interest-bearing debt of $6,000 and a portion of long-term debt due in the current period of $1,000.
Working capital in this scenario equals $100,000 – $30,000, or $70,000. Making the adjustments to working capital above, the working capital in valuation calculation is: $100,000 – $20,000 – $5,000 – $30,000 + $6,000 + $1,000 = $52,000
Working capital in valuation typically gives a lower dollar figure than the regular working capital metric. This can make a large difference when valuing companies. To be accurate, make sure to include any adjustments that make sense for the specific analysis of your client’s business.