Great post! Being able to understand working capital is very important to every business, and you explained it very well. Thanks for sharing that information!

@guest thanks for the note... to summarise, are you suggesting to look at WC on a net 12 month basis? And, to consider the effect that WC should have on EV on a case-by-case basis?

I agree that it's a little formulaic to apply a working capital % to growth assumptions and deduct that drain from the cash balance. And I agree there are more accurate ways to truly reflect the burden of WC, but it's tough to implement them (and communicate them) in my opinion.

I find the posting and series of comments quite confusing and in the end they seem to obfuscate the issue which as you have said is fairly straightforward.

Is working capital "included" in Enterprise Value - absolutely yes in the sense that the EV is a going concern valuation of the whole business equipped to conduct its business, ie with a normalised level of working capital and appropriate investment in capex. Does that mean that we subtract WC from EV to get to Equity Value? Absolutely NOT.

You're getting the sides of what might be called the Market Value Balance Sheet muddled up:
- on one side you've got operating assets -- tangible fixed assets, working capital, intangible assets and goodwill which make up the "asset" side
- on the other you've got the financing structure -- the Equity and Net Debt you use to finance it (at market values obv).

These sides broadly speaking have to be equal - but note WC sits firmly on the "operating" side. Does it make up part of the value of the firm, of course, but it's not part of the EV equation in the conventional sense of the EV = EqV + Debt which is really only one way of looking at value. IMHO.

Alex,

I responded to the original post because I was looking for cogent arguments for excluding short-term interest bearing lines of credit from the "net debt" portion of the EV formula, especially if the firm's cash cycle permitted it to pay back all of its short-term borrowings at least once in a year.

Imagine a scenario (drawn from real world case) where a company has NO long term debt, but has a large working capital line of credit that charges a market rate of interest. Now imagine that this company draws against 100% of its available credit every April, but pays back 90% of the line's outstanding balance every October. Given this scenario, what is the firms Net Debt for purposes of the EV formula as applied in the sale of 100% of the business? What would its ND be if it payed back its LOC 100% every October? What if it drew down and payed back its LOC 100% multiple times a year?

I agree with your view that the EV formula is intended to exclude debt in the financing structure and NOT debt in the operating structure, as the latter are correctly part of the "operating assets" of the going concern, despite being for accounting purposes, labeled as short-term liabilities.

Sadly the internet is littered with comments arguing that the debt in EV formula should include all "interest-bearing" debt or some other nonsense without addressing the "market value balance sheet" question that you outlined.

It's difficult to say intelligent things about your example without drawing it out or at least a spreadsheet but the 2 things missing from the analysis are appreciation of linkages of working capital and how they flow through time.

As long as the working capital completion mechanism is properly framed, it doesn't matter whether your item is Debt or Working Capital. If one the other will compensate, and vice versa. In practice it may be difficult to achieve which is why working capital negotiations can take as long as the rest of the deal put together. CF many and various Locked Box posts.

Obi Wan Kenobi once said "Only a Sith Lord deals in absolutes". To arrive at a balanced view of the subject and avoid group-think, one must ask whether the question is being posed in the context of a VALUATION (by an equity analyst who routinely values the equity of large publicly traded firms, for example, and who is usually more concerned with a single discrete theoretical per-share value) or the context of an actual real world M&A DEAL were a buyer and a seller are negotiating the deal terms of a controlling interest in an ongoing enterprise. The concept of Enterprise Value was created for the latter, not the former, and in its historical context has more often been associated with including "permanent debt" that acts as a substitute for equity, and not debt that facilitates trade or daily operations, whether or not provided by a bank.

In a deal context, seasonality in the use of working capital has a significant impact on the question of whether all working capital (whether or not interest-bearing), all the time, should always be included in the EV formula. A more nuanced approach, and one which reflects real-work practice, would exclude traditional current liabilities such as AP and accrued expenses, and would involve deeper analysis of short-term interest-bearing debt so as to uncover whether there is a pervasive outstanding balance over a 12-month period. Pervasive or "permanent" balances of short-term interest-bearing obligations are arguably a subsitute for equity (as obviously long-term debt is) and are therefore not operating assets of an enterprise, but a form of financing the long-term prospects of the enterprise.

If, in the context of an M&A deal, a buyer insisted on subtracting all current liabilities in addition to all the long-term debt to arrive at his view of equity value, then as a seller I would hand him the share certificates and the fixed assets, but I would keep the cash, the A/R and the inventory and I would not accede to a non-compete agreement. I therefore haven't sold an ongoing enterprise, I've sold ownership interests in a legal entity along with some fixed assets.