Working Capital Forecasts
I am doing a Valuation and would like to forecast working capital. I need a method that I can use to consistently make forecasts.
Currently, I just take historical changes in working capital and project them forward. I understand that this has serious flaws, including the assumption that market conditions stay relatively constant (i.e. companies are not hoarding cash or cutting back on inventories). That is why I need a better method.
I have financial statements and a Bloomberg Terminal that I can use to implement the method I choose for forecasting cash flows. Just FYI.
Also, I'm new so lmk if this thread belongs elsewhere in the forums.
working capital tends to grow as the company grows. for a quick estimate just assume at a percent of total assets. If you have a model with a growing company than wc will adjust accordingly.
Calculate A/R and payables days o/s, inventory turnover, etc., toss the inputs into your assumptions page so that it drives the balance sheet. I'd keep the assumptions on par with historical levels unless you have feedback from management or another source that indicates otherwise. Most companies push for longer A/P days (free financing for company) and shorter A/R days (free financing for supplier).
Beware of highly cyclical companies if you are modeling on an annual basis only (typically a poor idea for the first two years at least of the projection period). They may have sufficient working capital during the beginning and end of the year, but not during certain seasonal cycles. Credit line capacity often fills the temporary voids, but you never know, especially if you're planning on drawing on the revolver to fund some aspect of a transaction.
havilape has it right, assuming you're working with a full balance sheet and income statement. If you're only given working capital (or change in working capital), you're probably going to have to take it as a percent of sales, or as a percent of total assets -- or take guidance from your superiors. In that case, it doesn't hurt to grow the change in working capital at a rate equivalent to projected sales growth.
However, if given enough data, definitely go with days and turnover. This will let you get more detailed, and, as havil noted, it will allow you to adjust for cyclicality. This will allow you to adjust days over time, as the company's growth and continued partnership with vendors and customers will generally afford it more days payable and less days outstanding. Also will allow you to adjust for inventory turnover, as it's expected that the longer a company is in business, the more refined and efficient its inventory process will be.
So you guys are right, everyone does use days for working capital, but its kind of a joke. It's the same result as the % of sales since turn = Cogs / Inv and COGS is likley grown as a % of sales.
I think its just a more meaningful number to work with, but for modeling purposes its faster to use % of sales.
WC as a percent of sales is how I typically do it
BCbanker, it's just a matter of the number being more purposeful. Nothing more than an extra calculation to get days from % of sales, but days certainly mean more than the simple % of sales.
Also allows one to do more intricate calculations with other working capital accounts, as opposed to treating the change in WC as a percent of sales.
Thanks for your responses.
So, what I got is: Cash: Safety cash (I usually just assume it's relatively constant, which is the case with the co's I'm looking at) Inventory: Use inventory turnover A/R: Use days receivable outstanding A/P: Use days payable outstanding
Since I have sales forecasts already, this should'nt be too hard. However, should I use only the most recent ratio or should I do some sort of simple/arithmetic average of ratios from past years?
Mean. You're trying to find the "normal" year.
Thanks. So by "mean," you mean arithmetic average, right?
It really shouldn't be a simply of the past X years or periods unless you have reason to believe the most recent data is atypical. If they have spent time renegotiating supplier agreements to arrive at their Q1 2010 A/P days, you should use the most recent figures as they are the most accurate and will likely carry on into the future. If there are obvious aberrations that contributed to sharp changes in A/P or A/R days, then look to normalize it with past periods if it's a one-time issue. Short-term liquidity issues with the Company or with a major customer will cause these working capital metrics to spike in ways that are not representative of future periods.
And yes, mean is synonymous with arithmetic average, at least in the U.S.
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