working cap and cash

Hi all,

Just want to confirm my understanding of the correct treatment of working capital and cash in a DCF calculation.

The assumptions are:
1) Forecast balance sheet has been provided with various types of current asset and current liability items;
2) The company also possesses a decent amount of cash.

My questions are:
1) In calculating the forecast the working capital balance for DCF analysis, is the correct approach to base it on Current assets (excluding cash) – Current liabilities;
2) In addition, should forecasts of working capital balance always exclude cash – I am asking this because I have come across models where the analyst has forecast the balances Cash, AR, Inv and AP by multiplying their current balances by the increase/decrease in turnover;
3) And, if the forecast working capital balance excludes cash, does it automatically imply that the cash balance is excess cash and should be treated as a surplus asset to derive the equity value? I am asking this because I have seen models where the forecast working cap excludes cash and treats the cash as a surplus asset and models which assumes the cash is operating.

Thanks.

 

Answer is it all depends on the company. McKinsey says 20% of cash is deemed "operating" and thus must be used in calculating WC, with the remainder "excess". Is the company likely to draw on cash reserves for a major capital project? What are the operating vs non-operating cash percentages of industry peers?

Valuation really is more art than science..

 
Best Response
ChimpChange:
Answer is it all depends on the company. McKinsey says 20% of cash is deemed "operating" and thus must be used in calculating WC, with the remainder "excess". Is the company likely to draw on cash reserves for a major capital project? What are the operating vs non-operating cash percentages of industry peers?

Valuation really is more art than science..

I suppose I am just trying to confirm the appropriate treatment for the following scenarios:

a) Hypothetically, 100% of cash is operating

In this case, when I project the future working cap balances from the projected balance sheet, should I simply sum up (Current assets (incl. cash) - Current liabilities), and since all the cash is operating, I will not add the current cash balance to the enterprise value and deduct debt to derive equity value;

b) Hypothetically, all cash i non-operating

In this case when I project the future working cap balances, should I exclude cash in my equation (Current assets - Current liabilities), but add cash to Enterprise value and deduct debt to derive equity value.

Is my understanding correct?

Thanks.

 

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