Introduction to Incremental Net Working Capital Investments
This is the seventh step in the process of valuation. The Incremental Net Working Capital Investment is the net investment in the Net Working Capital (current assets less current liabilities). Under normal circumstances any growth in sales increases investment in Net Working Capital (NWC). This is the operating cash outflow for the company. This investment can either be mentioned in absolute numbers or one may use a percentage of incremental networking capital to incremental sales to estimate this.
| Incremental Working Capital Rate (%) |
= |
Incremental Net Working Capital Investment |
|
|
Incremental Sales |
You may use the latest Net Working Capital (NWC) Investment Rate as on the date of the latest financial statements to arrive at the Incremental Net Working Capital Investment Rate.
|
|
Net Working Capital |
|
|
Sales |
However, a few important points need to be taken care of while computing this, else they will impact valuation viz.,
- Short-term borrowings should be excluded from current liabilities and will form a part of debt and obligations.
- Cash and Securities, and investments in financial assets should not be included in net working capital.
- Overdue Payables should be removed from current liabilities and should be added to other liabilities, else this will impact the valuation.
- Long-Term Receivables (> 12 Months) should be added back to receivables since it affects the investment rate. We are trying to arrive at what the business investment rate of the company is.
- A significant portion of the value of a company is in the terminal value (Capitalization of the Free Cash Flows in the Target Year of the Forecast Period to perpetuity). The target Net Working Capital Investment Rate in the last year of the forecast period) is also any important driver for this value therefore, one needs to determine the Target Net Working Capital Investment Rate carefully.
Example for Computation of Investment Rate for Black Bay Pizza
Table 6 illustrates the computation of Incremental Fixed Assets and incremental Net Working Capital for Black Bay Pizza based on the following assumptions:
Assumptions
| Forecast Period |
5 Years |
| Sales in Prior Period |
1000 |
| Sales Growth, CAGR 1-3 Years |
15% |
| CAGR 4-5 Year |
12% |
| Operating Profit Margin 1-2 Years |
15% |
| Operating Profit Margin 3-5 Years |
18% |
| Incremental Fixed Assets Investment Rate |
35% |
| Incremental Working Capital Investment Rate |
30% |
Table 6 - Computation of Investments
| Year |
0 |
1 |
2 |
3 |
4 |
5 |
| Sales |
1,000 |
1,150 |
1,323 |
1,521 |
1,703 |
1,908 |
| Incremental Sales |
|
150 |
173 |
198 |
182 |
205 |
| Incremental Fixed Assets |
@35% |
53 |
60 |
69 |
64 |
72 |
| Incremental Working Capital |
@30% |
45 |
52 |
60 |
55 |
61 |
In the above computation, I have multiplied the incremental fixed asset rate of 35% with incremental sales of 150 (1150 -1000) to arrive at an incremental fixed asset investment of 53 for the first year and so forth.
Similarly, we multiply the incremental net working capital rate of 30% with incremental sales of 150 (1150 -100) to arrive at an incremental NWC investment of 45 for the first year and so forth.
Though I have kept a standard rate for all the years, in actual practice this could vary from year to year depending upon the plans of the company and the information available to the person undertaking the valuation.
The investment rate computed for Black Bay Pizza is 65% (incremental fixed asset investment rate plus incremental net working capital investment rate).