Find Net Working Capital as a Percentage of Sales

Hi guys, i'm doing a valuation.

I'd like to forecast the net working capital, in order to have the change in net working capital for my FCF calculations.

My plan was to keep it constant in percentage of Sales. Currently NWC is at 24% of net revenues.

So my question is: what is a typical percentage of NWC over Sales. Does 24% seem reasonable? Does it depend on the industry? Should I make it rise, drop or stay constant during my explicit forecast horizon?

Thank you very much!

What is Net Working Capital?

Before diving into this question it is important to understand what net working capital is - Current Assets - Current Liabilities. This represents the cash that is needed to operate the business.

NWC as a % of Sales

Finding net working capital in a financial model and in the free cash flow calculation is as much an art as it is a science. Often times analysts look at NWC as a % of sales in any given year.

The NWC relative to sales varies by industry as net working capital can represent 2% of sales or even 20% of sales. If a business requires a lot of current assets to generate sales (and those assets are funded by cash) then the net working capital as a percentage of sales will likely be high. If a business has high operating leverage then there will likely be a low % of NWC relative to sales.

When attempting to determine a % of sales for your model, you should be looking at the historical % of sales for the company as it will often not change too dramatically over a 5 - 10 year period of time. You should also look at the industry average. If there is a consistent NWC as a % of Sales for the peer group - the % of sales might be safely assumed to be the similar for the target company.

User @Wasserstag526", a corporate finance associate, explained looking for the industry average:

Wasserstag526 - Corporate Finance Associate:
I would look up some peer companies and find out what their working cap/sales ratio is and then take an average and use that. This is where the art part of valuation comes in to play. You always want support for decisions like this. An industry average for working cap to sales is standard practice.

Once you've settled on a % of sales - our users suggest that you keep it as a constant percentage throughout the projection window.

Wassertag526 - Corporate Finance Associate:
It generally depends on the industry, as each industry has it's own specific liquidity needs. I would say 5% of sales is a general back of the hand rule of thumb. I would keep it as a fixed percentage of sales.

Alternatively, you can project each line item of working capital.

techiee:
You have to project every sub item of the above Current Assets and Current Liabilities. Calculate days outstanding A/P, A/R etc ratios

One final note is that you should not necessary decline the net working capital as a % of sales throughout the projection window (IE going from a 15% historical number down to a 5% number in the terminal year). If working capital are the funds that are needed to run the day to day operations of the business, that % will not necessarily fall as time goes on. It will likely only change if the operations of the business become more or less efficient - IE more / less assets are needed to generate a given amount of revenue.

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It generally depends on the industry, as each industry has it's own specific liquidity needs. I would say 5% of sales is a general back of the hand rule of thumb. I would keep it as a fixed percentage of sales, and obviously subtract the change in WC from your FCF calculation.

'We're bigger than U.S. Steel"
 

Honestly, the best approach is prob to do peer group analysis. I don't know much about that sector but I would look up some peer companies and find out what their working cap/sales ratio is and then take an average and use that. This is where the art part of valuation comes in to play. You always want support for decisions like this. An industry average for working cap to sales is standard practice.

'We're bigger than U.S. Steel"
 
JulianWells:
I really don't see how you can call driving each WC account separately off of days sales/cogs "granular." Aren't you using a model?

You can't see how projecting each individual component of WC separately is granular compared to simply taking a % of sales?

'We're bigger than U.S. Steel"
 

% sales seems right. I'd look at the industry averages to quality check. I also tend to include base, upside, downside cases with a toggle/switch that way I'm prepared if my MD gives me any shit. Hope it helps bro.

its one way or the other: hate me or admire.
 

Its obviously MORE granular, but it's still a really simple exercise, not to mention the fact that it's the right way to do it. My view is that if you're conflicted in trying to come up with a blanket driver, just break it down. Takes 20 minutes at most, way less if you're using a model. You can even lump the CAs and CLs together and just drive those 2 accounts separately based on historical days sales/cogs. Then you'll have a change in NWC you can actually support vs. popping a % of sales figure in based on peers. Similar companies can have very different WC procedures. Just my 2 cents.

 
JulianWells:
Its obviously MORE granular, but it's still a really simple exercise, not to mention the fact that it's the right way to do it. My view is that if you're conflicted in trying to come up with a blanket driver, just break it down. Takes 20 minutes at most, way less if you're using a model. You can even lump the CAs and CLs together and just drive those 2 accounts separately based on historical days sales/cogs. Then you'll have a change in NWC you can actually support vs. popping a % of sales figure in based on peers. Similar companies can have very different WC procedures. Just my 2 cents.

Fair enough

'We're bigger than U.S. Steel"
 
JulianWells:
Its obviously MORE granular, but it's still a really simple exercise, not to mention the fact that it's the right way to do it. My view is that if you're conflicted in trying to come up with a blanket driver, just break it down. Takes 20 minutes at most, way less if you're using a model. You can even lump the CAs and CLs together and just drive those 2 accounts separately based on historical days sales/cogs. Then you'll have a change in NWC you can actually support vs. popping a % of sales figure in based on peers. Similar companies can have very different WC procedures. Just my 2 cents.
If WC is not a significant driver in the model, I wouldn't spend more than 1 minute on it. If Net WC as % of sales has been stable for the past few years and isn't a significant number, there's no point in breaking it down further unless you need to build a very detailed model for some reason e.g. for an acquisition or merger. Only time I would is if historical Net WC had significant swings then I would break it down to see what the cause was and then make assumptions for projections.
 

I'd have to agree with the above; work with each individual WC account and forecast based on historic number of days. For a lot of companies you will notice a possible cyclicality in NWC; make sure to read up/look this up for your industry and see if it comes into play. I also have to mention that I've never used % of sales method for this, it was simply easier to justify the days method and adjust individually for my MD, as needed. Hope this helps.

 

look at historicals of company and comps. days calculation will get you to same result as %. just make sure you use appropriate denominators (sales vs. cogs). only difference in days is that it has the added constant of 365 in the formula. agree though, that optically days are what many are used to seeing.

-- sm
 
speedmerchant:
look at historicals of company and comps. days calculation will get you to same result as %. just make sure you use appropriate denominators (sales vs. cogs). only difference in days is that it has the added constant of 365 in the formula. agree though, that optically days are what many are used to seeing.

If you want to get real anal about it you can factor in the impact of leap years with 366 every 4th year or break it out to 365.25... I think it's absurd but I've had people obsess about this point...

 

My response maybe repetitive to some of the above responses. To do a through WC forecast you'll need to:

1) look at comparable public company WC/Sales ratio (CapIQ, Yahoo) 2) look at private company WC/Sales ratio, needs to be in the same industry (you can find this data from Risk Management Associates (RMA), First Research etc.) 3) look at historical subject company WC/Sales ratio (this will capture changes in Assets & Liabilities and you'll not have to project each line item individually) 4) if possible ask subject company senior management to give you guidance

Take the result of all these and make an educated decision of what the ideal WC/Sales should be for your subject company. In the past I've used public company wc/sales ratio alone, but I've also used an average of subject company & public company wc/sales ratio.

If the subject company WC/Sales deviates vastly from other public & private comparables, you'll need to ask management why this is.

 

You do not project all the current assets... for working capital purposes you only calculate the ones that the firm can influence ie ST tax liabilities are not modified... as for the debt payable, you don't calculate that there, you include it in the debt schedule and for modelling purposes consolidate with all debt...

you have to understand the company's books in order to accurately project working cap... you have to understand where the inefficiency is in both the recievables, payables and a reasonable adjustment in order to increase cash but not destroy relationships... so if you want to do hairline adjustments, you can increase/decrease by a few turns/days to conservatively increase cash.

if working cap increases thats negative cashflow... if working cap decreases thats positive cashflow...

capex is always negative to cashflow unless its an asset disposition in which case it increases cash....

 
TallMonkey:
But What accoutns of Current Assets and Liab I shoud not forecast ? How about cash and short term investmets? notes payable? Would you know i could see an example in excel ? thanks !

cash is linked to the end cash balance in the CF statement... Notes payable is flowed from the debt schedule through the cashflow and should not be visible in the balance sheet.... for modeling purposes, it should be consolidated with it's respective debt piece...

standard accounts: A/R Inventory & WIP Prepaid Expenses Other current assets

A/P Accrued Expenses Other Current Liabilities

 
TallMonkey:
But What accoutns of Current Assets and Liab I shoud not forecast ? How about cash and short term investmets? notes payable? Would you know i could see an example in excel ? thanks !

cash is linked to the end cash balance in the CF statement... Notes payable is flowed from the debt schedule through the cashflow and should not be visible in the balance sheet.... for modeling purposes, it should be consolidated with it's respective debt piece...

standard accounts: A/R Inventory & WIP Prepaid Expenses Other current assets

A/P Accrued Expenses Other Current Liabilities

 
Best Response

The best way to determine what Working Capital will be in the future is to look at what it has been in the past. Working capital is incredibly dependent on not only industry, but business model and individual company dynamics as well. Two direct competitors can have vastly different working capital as a % of sales if one is more efficient in processing inventory, collecting receivables, stretching payables, etc. I personally would recommend going with the simplified approach of keeping WC as a % of sales constant in the projected period. While calculating ratios such as Days Outstanding, Inventory Turns, etc. is definitely a more granular methodology, the two methodologies will ultimately result in a very similar working capital number if you don't have any reason to believe that the ratios will change in the future. In fact, unless you project gross margin improvement, the two methodologies will produce the exact same working capital numbers assuming you carry forward the ratios from the current year. (Sorry if I got too complex here).

To MrLondon: I think you should DEFINITELY spend more time understanding working capital and how it impacts a company from a conceptual level because your comment suggests that you don't quite get it yet. You mentioned that this company "sells hydraulic valves." That alone really doesn't tell us anything. Is it a manufacturer? A distributor? Are the valves custom made for each customer or are they sold in large quantities by SKU number? These are the sorts of things that will truly influence working capital.

CompBanker’s Career Guidance Services: https://www.rossettiadvisors.com/
 
CompBanker:
To MrLondon: I think you should DEFINITELY spend more time understanding working capital and how it impacts a company from a conceptual level because your comment suggests that you don't quite get it yet. You mentioned that this company "sells hydraulic valves." That alone really doesn't tell us anything. Is it a manufacturer? A distributor? Are the valves custom made for each customer or are they sold in large quantities by SKU number? These are the sorts of things that will truly influence working capital.

CompBanker thank you very much for your answer. Do you have a good book to recommend in order to grasp NWC (and I suppose other things as well) better, from a conceptual point of view?

 
MrLondon:
CompBanker:
To MrLondon: I think you should DEFINITELY spend more time understanding working capital and how it impacts a company from a conceptual level because your comment suggests that you don't quite get it yet. You mentioned that this company "sells hydraulic valves." That alone really doesn't tell us anything. Is it a manufacturer? A distributor? Are the valves custom made for each customer or are they sold in large quantities by SKU number? These are the sorts of things that will truly influence working capital.

CompBanker thank you very much for your answer. Do you have a good book to recommend in order to grasp NWC (and I suppose other things as well) better, from a conceptual point of view?

I unfortunately do not. If you have a mentor at your shop that you can trust, consider asking him/her how to think through the business factors that influence working capital.
CompBanker’s Career Guidance Services: https://www.rossettiadvisors.com/
 

If you have the IS and CF Statements, I would use the change in working capital from the CF and divide by incremental revenue. Then multiply this number by the total revenue. This will be even more valuable if you have more than 1 year and can compute an average working capital requirement. Or if you dont have the CF but you know the industry you could use an industry average WC per Revenue.

 

I actually don't have CF, I need to draft one. So I don't have the change in working capital information. I do have this piece of info though: "Actual cash balance at the end of 2010 will be $5 million. Starting in 2011, it is planned that working capital other than cash will compound at the same rate as sales and increase by these incremental amounts only."

Not sure what I can do with this without beginning working capital balance though..

 

I guess, the only reliable way to do this is make the assumption that you are finding Working Capital from day 0, I.E. when the company incorporated. If you don't know that NWC = 0 at the beginning, you can't extrapolate what it is without the balance sheet or Cash Flow Statement, unfortunately.

Do you know the problem to be asserting that it is Year 0?

 

Use your knowledge about the company's business model, comparable business models, etc. to determine what an appropriate level of working capital is as a % of sales. Does the company have a lot of inventory? Do they have a lot of power over suppliers to negotiate better payment terms? How about the customers, what kinda power do they have to determine whether they pay net 30, 45, 60, etc. days? Good assumptions could really set you apart from your peers.

CompBanker’s Career Guidance Services: https://www.rossettiadvisors.com/
 

agree with Comp. I forget the name of the source we used to use, but there are definitely sources that give wc as % of sales by type of company.

I used to do corporate finance work with small companies where ownership (aka the rich guy that doesn't do much) can radically change the company's balance sheet. We would always look at an appropriate working capital level for the companies using % of sales from some reference we had.

twitter: @CorpFin_Guy
 

LOL?

Didn't they teach you to project out all the line items and net current assets/liabilities? It takes a min longer to do and you'll have more accurate projections.

The increases/decreases in working capital is just the changes in net working capital YoY, so your real question should be whether it's plausible to peg net working capital to sales.

 

If you assume that NWC is a constant % of sales, then the % change in NWC is equal to the % change in sales, so yes, I suppose you could do that without projecting out the balance sheet. What you should NOT do is project the change as a % of total sales. Just make the % change equal to the YoY % change in sales.

This is all kind of a lazy and back of the envelope way to do things anyway. What you should really be doing is projecting out the individual items of working capital by using the ratios that drive those values (DHI, DSO, DPO, etc.). Doing it the lazy way can imply really meaningless and unrealistic ratios that a company would never have or never be able to achieve.

 

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