By George Azar, ICVS (MIE00430)
The Working Capital Conundrum in Business ValuationsAs an active IACVS member, I adhere to both IACVS standards and the International Valuation Standards (IVS) in my valuation engagements. While the IVS covers in detail the full spectrum of asset standards, IVS 200 (business and business interests), IVS 210 (intangible assets), IVS 220 (non-financial liabilities), IVS 230 (inventory), IVS 300 (plant, equipment, and infrastructure), IVS 400 (real property interests), IVS 410 (development property), and IVS 500 (financial instruments), the IACVS standards place particular emphasis on privately held businesses.
Through continued collaboration and professional development, the valuation community refines its understanding of evolving topics and strengthens the technical foundations of valuation practice.
One issue that frequently emerges in valuation advisory work is the misinterpretation of working capital in business valuation, especially when the basis of value is market value, investment value, or synergistic value.
In these contexts, the income approach is commonly applied to determine enterprise value and, subsequently, equity value. However, the treatment of working capital within this framework can significantly impact the reliability of a valuation analysis. Temporary fluctuations in operating assets and liabilities may distort the underlying liquidity position of a business if not properly examined.
Academically, equity value is derived by adding cash balances to enterprise value and deducting outstanding debt as at the valuation date. Other balances, such as receivables, prepaid expenses, stock, accounts payable, and advance payments, are often entirely ignored based on the assumption that working capital is implicitly captured within the income-generating value of the business. This approach treats working capital the same way it treats income-producing fixed assets, which are necessary to generate revenue, profit, and cash flow.
While this rationale may hold for fixed assets, it does not always apply to normalised working capital. The observed level of working capital on the valuation date may not reflect the business’s required operating range. When actual levels fall outside sector benchmarks, the omission of an adjustment can lead to an understated or overstated equity value. This highlights why careful working capital analysis remains a fundamental part of producing a reliable and defensible valuation.
In valuation practice, fixed assets are separated into income-producing and non-income-producing categories, with the market value of the latter added to the business’s income-generating value because their disposal has no effect on operations.
A similar principle applies to working capital. Not all observed working capital is required to sustain operations, and levels may sit above or below what is reasonable for the sector. When this occurs, adjustments are necessary to ensure that the resulting enterprise value assessment remains accurate and defensible. For this reason, working capital in business valuation must be analysed with the same care as other normalisation adjustments applied to cash flows and profitability.
The concept of normalisation is widely used in valuation analysis and is routinely applied to operating profit, cash flow, and other financial indicators, particularly when excluding non-recurring revenues or expenses before applying valuation multiples.
The same principle applies to normalised working capital, which may show either a surplus or a deficit relative to the level required to support sustainable operations. When analysts overlook this step, the resulting valuation may not reflect the business’s true financial position.
To illustrate the importance of working capital in business valuation, it is useful to examine real examples drawn from regional, privately held businesses for which I was engaged as an independent valuer.
The first case involves a business operating in the energy sector, specifically in the import and wholesale distribution of refined oil. On the valuation date, the company held an unusually high level of fuel stock, almost twice the daily average for the year. Only a few weeks later, this stock level decreased significantly, almost entirely offset by an increase in cash and bank balances. Had a normalisation of the working capital ratio not been applied, the valuation would have been understated, as the excess stock, which soon converted into cash, would have been disregarded.
A second case concerns a wellness business with significant overdue payables, resulting in a current ratio well below 1:1. Several factors contributed to this liquidity deficit, including high dividend payout ratios that reduced excess cash, the lack of accounts receivable due to the cash-based nature of the business, and minimal stock levels.
Stretched payment terms to suppliers and outstanding dues to third parties further widened the shortfall. Without an adjustment for normalised working capital, the valuation would have overlooked a liquidity gap that fell well outside the sector’s benchmark range, leading to an overstated equity value.
These examples reinforce the importance of analysing the working capital position at the valuation date and comparing it with relevant sector and regional benchmarks. Deviations from expected ranges should be reflected in the valuation outcome, as they extend beyond cash and debt balances. Proper treatment of working capital ensures that enterprise value and equity value assessments remain aligned with the operational reality of the business, providing a more dependable basis for valuation advisory work, financial due diligence, and negotiations.
A rigorous assessment of working capital in business valuation strengthens both the accuracy and defensibility of the final valuation figure. Ensuring that working capital is normalised in the same manner as earnings, cash flows, and other elements of the valuation process supports clear, transparent outcomes.
Firms such as DG Jones & Partners, through their specialised technical advisory services, emphasise this analytical discipline to maintain precision and consistency across valuation engagements. By approaching working capital with the same level of scrutiny as other financial metrics, analysts can better reflect the economic conditions under which the business operates and arrive at a valuation that withstands professional scrutiny.
