If a company has had net working capital levels of approximately 12% of sales over the past five years, it can be reasonably estimated that the company will continue to require that level of working capital to support future sales. Therefore, it may be appropriate to add any working capital amount in excess of 12% of sales as of the valuation date to the determined company value as excess working capital (essentially a non-operating asset). A related adjustment may be made that would reduce the company's value for deficient working capital if the company had a net working capital balance below its historical levels as of the valuation date.

Example:

Company Z has $1.2 million of net cash flow (NCF) for simplicity purposes let's assume for the industry a valuation multiple for NCF is 4.0 so we have $4.8 million Entity Value

Working Capital of $1.5 million, of which is $500 thousand, is considered a working capital surplus and therefore is added to the purchase price.

$4.8 million Entity Value plus $500 thousand excess working capital = $5.3 Million value.

Discussion Matters:

Does the excess cash represent a return on the seller's investment? From a valuation standpoint, theoretically, if we used the discounted cash flow method or capitalized cash flows method we would arrive at the same $4.8 million value, didn't we use the same cash as part of the valuation of cash flows? Is this a double-dip?

I understand the mechanical nature of why valuation analysts add this back; however, is it correct?

For example, if you a simple average of 5 year of either income or cash flow of: year 1 100 year2 100 year 3 100 year 4 100 year 5 100 total 500 average 100 cap rate 0.2 value 500

Now you go to the balance sheet as of the valuation date and have a cash balance of $500 and the industry working capital benchmark is $200, is it fair to add $300 to the value of the business? That is really the question. In practice, particularly matrimonial valuations, some practitioners would opine, if the owner sells the business they would realize $500 in value plus $300 in excess working capital for a total value of $800.

Remember the value included the $300 ($100 each year), possibly not distributed cash flow/earnings, is that really value?