Understanding Incremental Net Working Capital Investments in Business Valuation
Determining the Incremental Net Working Capital Investment is a crucial step in the business valuation process. It represents the net investment in the Net Working Capital (current assets minus current liabilities). Typically, any growth in sales results in an increase in Net Working Capital (NWC), which represents the operating cash outflow for the company.
Net Working Capital is calculated as ((Current Assets - Cash & Short Term Investments) - (Current Liabilities - Short Term Borrowings) - (Non-current Deferred Revenue)).
When forecasting NWC Investment, it can be expressed either in absolute numbers or as a percentage of incremental networking capital to incremental sales.
The Incremental Working Capital Rate (%) is determined by dividing the Incremental Net Working Capital Investment by Incremental Sales. This rate can be computed over a specific period, such as 5 or 10 years, to account for abnormalities and then used for forecasting. The formulae is as follows:
| Incremental Working Capital Rate (%) | = | Incremental Net Working Capital Investment |
| Incremental Sales |
Alternatively, the latest Net Working Capital (NWC) Investment Rate from the most recent financial statements can be utilized to estimate the Incremental Net Working Capital Investment Rate. The formulae is as follows:
| Net Working Capital |
| Sales |
However, certain factors must be considered during computation to avoid impacting valuation :
- Short-term borrowings should be excluded from current liabilities and treated as debt and obligations.
- Cash, securities, and investments in financial assets should not be included in net working capital.
- Overdue payables should be moved from current liabilities to other liabilities to avoid affecting valuation.
- Long-term receivables (>12 months) should be added back to receivables as they influence the investment rate. The aim is to determine the company's business investment rate.
Negative Working Capital is a concept observed in certain businesses, such as Retail or SAAS companies, where collections occur in advance or cash is collected before payments are made. In such cases, working capital can be negative.
Sam Walton, the American businessman and entrepreneur, introduced the concept of 'Net Working Capital' as a key driver of value. He would order products in large quantities, hold blowout sales events, and use the profits to expand his empire.
When conducting business valuations, it's crucial to exclude cash and marketable securities, short-term borrowings, and overdue payables from net working capital. Additionally, long-term receivables (>12 months) should be added back to receivables as they impact the investment rate, which aims to determine the company's business investment rate.
Example for Computation of Investment Rate
To illustrate the computation of investment rates, Table 1 provides an example based on various assumptions. It calculates Incremental Fixed Assets and Incremental Net Working Capital for a five-year forecast period, considering sales growth, profit margins, and investment rates.
Note that the provided table showcases a sample computation, and actual rates may vary depending on company plans and available information during the valuation process.
The following Table illustrates the computation of Incremental Fixed Assets and incremental Net Working Capital 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% |
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, the incremental fixed asset rate of 35% is multiplied 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, multiplying 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 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 business valuation.
The investment rate computed is 65% (incremental fixed asset investment rate plus incremental net working capital investment rate).