Leverage and working capital from valuation perspective
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This paper, looking within the energy sector, empirically tests the hypotheses that individual and/or net
working capital efficiencies impact a company’s enterprise value (EV). The EV metric is unique for it
allows an equity investor to assess the firm on the same basis as an acquirer in a merger-acquisition
transaction. It represents an option or ‘right’ to buy a firm’s core cash flow or the value of claims on that
cash flow. The results show there are significant negative associations between the net working capital
efficiencies and enterprise value for large and mid-cap firms. From the perspective of the investor-
acquirer, the acquisition cost of a company is directly impacted and it shows why they need to pay
attention as to how well firms simultaneously turn over their inventories, collect on trade receivables, and
service their trade creditors.
There is a trend in business where firms are starting to switch their focus from the uncertainty of the
profit and loss statement onto the balance sheet. This reluctance from moving away from the proverbial
‘bottom-line’ may be due to companies underestimating the role of the firm’s working capital. Working
capital is considered to be the excess of current assets over current liabilities and as such is a financial
metric measuring operating liquidity. Management should be looking at working capital that ‘nets’ out
cash, allowing them to focus on the operating assets of the firm. The intuition is to determine how cash
has changed over the period based upon changes in inventory, accounts receivable, and accounts payable.
This paper posits that by effectively managing the components of net working capital, companies can
enjoy financial flexibility and influence a company’s enterprise value (EV) through a reduction in capital
employed and subsequent asset productivity. As discussed later, this approach is reinforced by the fact
that the calculation of the enterprise value is dependent upon including the value of all the non-operating
assets that have been netted against cash.
The determination of the enterprise value (EV) metric allows investors to assess the firm on the same
basis as an acquirer. It can be viewed as a theoretical takeover price where the acquirer accepts the debt of
the firm but is also entitled to its cash. This paper argues that in an attempt to place a value on a company,
the buyer or seller has to reconcile the purchase price (i.e., enterprise value) to the periodic fluctuations in
the working capital investment that is needed to support the operations of the company. Generally, the
goal is to minimize the capital earmarked to a company’s turnover process by reducing accounts
receivable and inventory, while extending accounts payable (Rafuse,1996).
As stated previously, working capital can be seen as a means for evaluating the operating liquidity of a
corporation. However, it also can signal its operational efficiency. A positive working capital position
implies the ability of the firm to cover its current obligations while an increase in the levels of the
working capital accounts can mean that too much money is tied up in the business. An effective
management of working capital centers on operational asset positions in inventory, accounts receivable,
and accounts payable. Excess cash and non-operational items are excluded. This paper posits that the
enterprise value metric for an investment opportunity acts as a real option. It represents the cost of buying
the right to a company’s core cash flows or the value of the claims on those cash flows. When a buyer
assesses a firm on the same basis as that of an acquirer, the enterprise value (EV) is analogous to a call
option on the total value of the firm’s operations that is measured by taking the market capitalization of
the firm and adjusting it for debt, minority interests, preferred stock, and other provisions deemed debt
and reducing it by the excess cash of the firm. In other words, it represents an option to buy the debt and
other liabilities of a firm after cash flow considerations. Major determinants of this excess cash are the
components of the working capital cycle. Cash flows improve when companies utilize the right level of
working capital that tends to release funds that are bound up in operating accounts. It is ‘found’ capital.
working capital efficiencies impact a company’s enterprise value (EV). The EV metric is unique for it
allows an equity investor to assess the firm on the same basis as an acquirer in a merger-acquisition
transaction. It represents an option or ‘right’ to buy a firm’s core cash flow or the value of claims on that
cash flow. The results show there are significant negative associations between the net working capital
efficiencies and enterprise value for large and mid-cap firms. From the perspective of the investor-
acquirer, the acquisition cost of a company is directly impacted and it shows why they need to pay
attention as to how well firms simultaneously turn over their inventories, collect on trade receivables, and
service their trade creditors.
There is a trend in business where firms are starting to switch their focus from the uncertainty of the
profit and loss statement onto the balance sheet. This reluctance from moving away from the proverbial
‘bottom-line’ may be due to companies underestimating the role of the firm’s working capital. Working
capital is considered to be the excess of current assets over current liabilities and as such is a financial
metric measuring operating liquidity. Management should be looking at working capital that ‘nets’ out
cash, allowing them to focus on the operating assets of the firm. The intuition is to determine how cash
has changed over the period based upon changes in inventory, accounts receivable, and accounts payable.
This paper posits that by effectively managing the components of net working capital, companies can
enjoy financial flexibility and influence a company’s enterprise value (EV) through a reduction in capital
employed and subsequent asset productivity. As discussed later, this approach is reinforced by the fact
that the calculation of the enterprise value is dependent upon including the value of all the non-operating
assets that have been netted against cash.
The determination of the enterprise value (EV) metric allows investors to assess the firm on the same
basis as an acquirer. It can be viewed as a theoretical takeover price where the acquirer accepts the debt of
the firm but is also entitled to its cash. This paper argues that in an attempt to place a value on a company,
the buyer or seller has to reconcile the purchase price (i.e., enterprise value) to the periodic fluctuations in
the working capital investment that is needed to support the operations of the company. Generally, the
goal is to minimize the capital earmarked to a company’s turnover process by reducing accounts
receivable and inventory, while extending accounts payable (Rafuse,1996).
As stated previously, working capital can be seen as a means for evaluating the operating liquidity of a
corporation. However, it also can signal its operational efficiency. A positive working capital position
implies the ability of the firm to cover its current obligations while an increase in the levels of the
working capital accounts can mean that too much money is tied up in the business. An effective
management of working capital centers on operational asset positions in inventory, accounts receivable,
and accounts payable. Excess cash and non-operational items are excluded. This paper posits that the
enterprise value metric for an investment opportunity acts as a real option. It represents the cost of buying
the right to a company’s core cash flows or the value of the claims on those cash flows. When a buyer
assesses a firm on the same basis as that of an acquirer, the enterprise value (EV) is analogous to a call
option on the total value of the firm’s operations that is measured by taking the market capitalization of
the firm and adjusting it for debt, minority interests, preferred stock, and other provisions deemed debt
and reducing it by the excess cash of the firm. In other words, it represents an option to buy the debt and
other liabilities of a firm after cash flow considerations. Major determinants of this excess cash are the
components of the working capital cycle. Cash flows improve when companies utilize the right level of
working capital that tends to release funds that are bound up in operating accounts. It is ‘found’ capital.
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