The enterprise value of a business is very important to creditors, especially if the business is distressed. Comparing enterprise value to the amount of debt determines whether a creditor has an equity cushion or is underwater. An appropriate assessment of enterprise value can help to accurately assess the debt capacity of a business. Thus, an enterprise value analysis is part of the foundation behind any restructuring. An understatement of value can result in creditors taking an inappropriately large haircut. Or, it may result in an incorrect conclusion to liquidate a business. On the other hand, an overstated value can result in over-leveraging a business, resulting in post-restructuring financial distress and reduced recoveries.

Accounting for working capital when valuing a business can present a unique set of challenges. Changes in working capital can have a material impact on enterprise value. Sometimes, working capital changes (and the associated cash-flow changes) are permanent in nature; such changes often result when a business grows. This business requires more inventory and generates greater accounts receivable. Growth results in permanent increases in inventory and accounts receivable, which can be used to secure borrowings. As long as a business does not shrink, changes in working capital resulting from growth can usually be financed permanently with accounts payable and revolving credit lines. When projecting cash flows for a growing business, an important consideration is the cash-flow impact of permanent changes in working capital that result from growth.

On the other hand, sometimes working capital changes are more temporary in nature, resulting in a cash-flow impact that will later be reversed. This is common with seasonal businesses that often experience the following cycle:

1. Just before a peak season, the company will build its inventory and will finance the purchase with borrowings secured by inventory and accounts receivable (usually in the form of a revolving line of credit).
2. During and just after the peak season, when the combination of inventory and accounts receivable is at its seasonal peak, the revolver balance is also at its peak.
3. As the inventory is sold and the accounts receivable are collected, the cash is used to pay off the revolver. Inventory, accounts receivable and the revolver all reach their troughs before the firm prepares to enters into its next peak season (returning then to the beginning of this cycle).

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[W]hen valuing a seasonal business using an annual DCF, it is of great importance to understand where the business is in its annual cycle. The timing of the valuation date within the firm's yearly cycle is critical to a correct valuation and assessment of solvency.

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Correctly identifying working-capital changes by type (permanent vs. temporary) is the first step toward correctly accounting for working capital. Seasonal businesses that are growing will have both types. Accounting for permanent changes in working capital when valuing a business is generally simpler than accounting for temporary changes. Additionally, it is particularly important to creditors of a distressed company to understand the impact of temporary working-capital fluctuations in determining whether the firm is above or below water.

The most common way to calculate enterprise value is to discount projected unlevered cash flows to their present value—i.e., to perform a discounted cash flow analysis (DCF). Similarly, the most common way to value the equity of a business is to subtract total debt from the concluded enterprise value. Changes in working capital must be properly projected and considered when developing a DCF. To do so can be complicated for businesses that experience fluctuations in working capital, such as firms in seasonal industries like retail, distribution, construction and some manufacturing.

Using a DCF to calculate enterprise value involves projecting operating and investing cash flows, including projected changes in working capital. If a DCF is prepared on an annual basis (as most DCFs are), seasonal changes in working capital will not be reflected in the projected cash flows as they will reverse during the same projected year—even though the seasonal changes will occur within a forecasted year. For example, during an off season, inventory, accounts receivable, accounts payable and the revolving debt balance will be at relatively low levels. During a peak season, inventory, accounts receivable, accounts payable and the revolving debt balance will be at relatively high levels. Since these seasonal balance-sheet account changes are not reflected in the cash flows of an annual DCF, the amount of excess seasonal working capital at the valuation date, if any, must be calculated and added to the results obtained from the discounting annual cash flows. This is particularly important when assessing the solvency of a business.

Consider a business that is not growing. At any valuation date, the annual cash flows generated by the business are the same. Therefore, without any adjustments, a DCF would result in the same enterprise value conclusion for this business regardless of the valuation date. However, the revolving debt balance for seasonal businesses can vary substantially within any given year, as it is used to finance the build-up of inventory and accounts receivable during peak seasons. If no adjustments are made to the value conclusions using a DCF, the concluded equity value of a seasonal business will incorrectly be lowest during its peak season, when revolving debt balances are highest, and highest during its slow season, when revolving debt balances are lowest. By simply observing the stock prices of publicly traded retailers and other seasonal businesses, it is obvious that equity values do not consistently decline during peak periods (e.g., the holidays) and increase during slower periods. Adjusting for seasonal swings in working capital will result in a correct calculation of enterprise and equity values.

Valuing Swings in Working Capital

Since the total debt and total assets of a seasonal business swing substantially in a typical year, these swings must be carefully analyzed and understood. To arrive at the right enterprise value and equity conclusions, the trough level for required working capital and for the line-of-credit balances must be determined. In a given firm, these items usually reach their trough levels just before this business begins building up its inventory for a peak period. The operating working capital and financing at this point in time can be considered the "permanent" portion of working capital and the "permanent" level of revolving debt.

A sample calculation of the permanent portion of a company's working capital, or the lowest level of required working capital within one operating cycle, is presented in Table 1 ($30 million). It is at this point in the operating cycle that the revolving debt is also at its trough, representing the permanent amount of revolving debt ($10 million). If a company is valued as of its trough period, no adjustments for excess working capital are necessary because the working-capital balance and the related revolving-debt balance are at permanent levels. Simply subtracting total debt from the enterprise value derived from projected cash flows results in a correct equity value conclusion (see Example 1 in Table 1).

However, if the valuation date is as of any other period, the excess working capital at that date—i.e., the working-capital balance (excluding revolving debt from the calculation) in excess of the trough level—must be added to the conclusion using an annual DCF to arrive at the appropriate enterprise value conclusion. From this sum, total debt should be deducted to calculate equity value. Excess working capital is often offset, at least partially, by an increase in the revolver balance. As a result, though a company's assets may increase as inventory is purchased and additional accounts receivable are generated, its liabilities also increase (as the revolver increases), and thus its equity value changes by very little (see Example 2 in Table 1). As illustrated in the example in Table 1, which assumes that all changes in working capital are financed with the revolver balance, equity value does not change each quarter, even though assets increase because the revolver balance also grows. This example shows the importance of making balance-sheet adjustments when determining the enterprise value of an entity for the purposes of evaluating a company's solvency position.

It is important to consider excess cash a company may use to finance some of its working-capital requirements instead of using revolving debt. Excess cash must be added to the value concluded using a DCF to correctly calculate enterprise and equity values. If excess cash exists, it will most likely be highest during trough seasons. In fact, it is likely that excess cash in peak seasons will only be evidenced by relatively low revolving-debt balances, and no excess cash will be available during peak seasons.

Much like working capital, if excess cash is accounted for correctly when it exists, equity values will not change through the seasons. This can be illustrated using the figures in Table 1. If the company had $10 million of excess cash at the trough, its enterprise and equity values would have been $10 million higher, or $110 million and $80 million, respectively. If the business used this excess cash during the next several months to finance some of its purchases of inventory, the company would have required $10 million less in borrowings. As a result, the enterprise value conclusion at the peak would have remained at $170 million, but the equity value would have been $10 million higher at $80 million because the revolver would have been lower by $10 million.

In summary, when valuing a seasonal business using an annual DCF, it is important to understand where the business is in its annual cycle. The timing of the valuation date within the firm's yearly cycle is critical to a correct valuation and assessment of solvency. The minimum amount of required working capital for a business must be determined, and any working capital above this amount should be considered excess and added to results obtained from the DCF. It is then appropriate to compare the enterprise-value conclusion to the total debt of the entity to evaluate its equity value and solvency.

Conclusion

Businesses often experience both types of working-capital changes: permanent, resulting from growth, and temporary, resulting from seasonality. Permanent working-capital changes should not be considered excess. The permanent portion must be separated from the temporary portion, and only the latter should be considered excess when calculating enterprise value. Finally, all of these valuation analyses may be irrelevant if a business does not continue as a going-concern. Inventory and accounts-receivable values in a liquidation are almost always below their going-concern values. When a company elects to liquidate, the relationship between the revolver and the value of a company's assets is usually dramatically altered; the methodologies described here to assess equity value or solvency would most likely not apply.

Footnotes

¹ Gary Durham is a senior associate with AlixPartners based in Dallas, where he assists companies in situations involving restructuring, recapitalizing, solvency analysis, business planning, valuation analysis, damage calculations and various litigation issues. He can be reached at 2100 McKinney Avenue, Suite 800, Dallas, TX 75201, (214) 647-7500, fax (214) 647-7501. Return to article