Working capital deficiency

February 19th, 2007 | Income Approach & Methods

We do not often hear the expression nonoperating liabilities in valuation. When we hear about the concept, it is either nonoperating assets, or excess working capital. A deficiency in working capital, then, is the other side of the equation. Several recent engagements have reminded me of the import of normalizing working capital before using an income approach to valuation, be it a DCF, CCF or excess earnings method.

When the premise of value is that of a going concern, the working capital assumption must be consistent with the industry norm, i.e., what a hypothetical buyer/seller would expect. A particular medical practice being valued may not necessarily have a normal level of working capital. Typical sources of working capital deficiencies include patient prepays or credit balances, accruals in excess of available cash for retirement plan contributions, and accrued vacation time, sick time or "personal time" where the practice permits unlimited or significant carryovers.

Accruals for personal time were long ago identified as an issue for GAAP financial reporting. Given that the typical medical practice sale is structured as an asset sale, the proceeds of that sale must be used to pay off all outstanding liabilities before anything is distributed to equity holders. If the subject practice permits unlimited carryovers of personal time, the magnitude of the liability may be shocking. Sufficient effort must be expended to determine what a normal level of personal time accrual is in order to have an appropriate measure of working capital in the valuation model.

Even in simple buy-in transactions, the valuation analyst or consultant must be certain to inquire as to this liability.  Excluding it could result in the younger owners being left "holding the bag" at some point in the future for a large unfunded liability – analogous to those defined benefit obligations of airlines and "old economy" manufacturers.

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