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Glide • Spring - Summer 2026 • Air
Beyond Standard Practice: Revisiting the Treatment of Net Working Capital for Valuation Purposes
By Sarah von Helfenstein | Dean Dorton Allen Ford PLLC | United States
In all fields of human endeavour, we tend to make critical breakthroughs in theory, methods, and techniques and then build approaches and systems around these that become mainstream and considered unassailable.
Business appraisal is no different. Yet, as history has repeatedly shown, all systems, all standard practices, have weaknesses that call for re-examination at some point. One such practice is the treatment of net working capital for valuation purposes.
In this paper, I begin with a review of foundational concepts of net working capital, its importance, its calculation, its effects on the enterprise and on cash flow analysis. From there, I examine current methods of treating it in valuation analysis. I point out where we may not have applied enough rigor to our techniques and methods and conclude with suggestions for a fresh look at net working capital and its role in valuation analysis.
Purpose of Review
As a matter of routine and time efficiency, certain inputs into our models become formulaic. The net working capital adjustment to cash flows fits into this category. While working capital is a subject of importance in finance and management literature, it gathers little attention in business valuation. Thus, a thorough review of baseline concepts is useful if we hope to explore any changes in practice.
Review: Definitions and Implications
Working Capital (Total Current Assets – Total Current Liabilities) is an accounting metric that provides an indication of a company’s short-term financial health (its liquidity and ability to meet short-term obligations), its effective financial management, operational efficiency, and longer-term viability.
The importance of understanding and utilizing it in valuation analysis is indicated in two quotes from the J.P. Morgan Working Capital Index Report for 2022 and 2024. These statements hold true in 2026 as well.
2022 has begun with a perfect storm of supply chain disruption, geopolitical tensions and quantitative tightening in response to the 40-year high inflation, which is causing volatility in the overall economy. Companies need to closely review their end-to-end supply chains to be able to withstand the supply shock in order to build sustainability and resiliency, which is heightening the pressure on working capital. Efficient working capital can also unlock significant value and free up cash for investing in strategic areas . . . ¹
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With a fast-evolving macroeconomic environment, higher interest rates and supply chain uncertainties, business should focus on strong balance sheet management, while always maintaining access to liquidity. Companies should also continue to focus on working capital optimisation opportunities. ²
Net Working Capital (NWC) is an abbreviated version of Working Capital. Also, Operating Working Capital or Non-Cash Working Capital, it is computed as follows:
Formula 1: (Total Current Assets – Cash & Cash Equivalents – Marketable Securities) – (Total Current Liabilities – Short-Term Interest-Bearing Debt – Current Portion of Long-Term Interest-Bearing Debt)
Cash, Cash Equivalents, and Marketable Securities are removed from Total Current Assets because they earn a fair return, function more like investing activities, and are not directly involved in core operations. Thus, they are also termed “non-operating current assets”.
Two exceptions to this rule are: 1) companies that operate in poorly developed banking systems; and 2) companies that must maintain high cash balances for day-to-day operations. ³ “To the degree that cash cannot be invested to earn market returns, and is needed for day-to-day operations, it is appropriate to look at changes in net working capital, with cash included.” ⁴
Termed “non-operating current liabilities”, Short-Term Interest-Bearing Debt (including the current portion of long-term interest-bearing debt) are removed from Total Current Liabilities because debt is a source of financing rather than directly involved in core operations. In addition, these forms of debt are explicitly considered in computing the cost of capital and in developing forecasted net cash flows. Inclusion in working capital would count them twice.
The simplified formulas for NWC are:
Formula 2: (Accounts Receivable + Inventory + Prepaid Expenses) – (Accounts Payable + Accrued Expenses + Deferred Revenue)
Formula 2a: Operating Current Assets – Operating Current Liabilities
In general, higher values for both Working Capital and NWC indicate more company stability and less liquidity risk. However, NWC is the metric of choice in valuation because it focuses explicitly on a company’s operational efficiency and its impact on free cash flows.
Working Capital Requirement (WCR), also termed Working Capital Peg or Non-Discretionary Working Capital, is the minimum cash balance that a company must maintain to meet its obligations in the next twelve months and sustain business continuity. The computation of WCR is identical to that for NWC, with some differences.
First, the WCR at the industry level differs for every industry. It also varies at the company level by revenue model and cost structure. In addition, seasonality and business cycle effects, if present, need to be considered by utilising a rolling twelve-month period to ensure at least one full cycle is captured. If the WCR is to be used for historical trend analysis or peer group comparison, it must be standardised, as follows:
Formula 3: Change in WCR ÷ Net Revenue
Negative Net Working Capital occurs when operating current liabilities exceed operating current assets. It can be a sign of operating efficiency, i.e., receivables are being collected efficiently, inventory is turning over quickly, and/or more advantageous payables terms have been negotiated. However, it can also be a sign of increased liquidity risk caused by lack of sales, reduced purchase of inventory due to declining customer demand, or cash mismanagement.
A firm that has a negative working capital is, in a sense, using supplier credit as a source of capital, especially if the working capital becomes larger as the firm becomes larger. A number of firms, with Walmart and Dell being the most prominent examples, have used this strategy to grow. While this may seem like a cost-efficient strategy, there are potential downsides. The first is that supplier credit is generally not really free. To the extent that delaying paying supplier bills may lead to the loss of cash discounts and other price breaks, firms are paying for the privilege. Thus, a firm that decides to adopt this strategy will have to compare the costs of this capital to more traditional forms of borrowing.
The second is that a negative non-cash working capital has generally been viewed both by accountants and ratings agencies as a source of default risk. To the extent that a firm’s rating drops and interest rates paid by the firm increase, there may be costs created for other capital by using supplier credit as a source. ⁵
Review: Historical Change in NWC (Δ NWC) and Interpretation
Formula 4: Change in NWC = Beginning NWC - Ending NWC
Δ NWC exhibits a counterintuitive impact on cash flows. Increases in NWC (i.e., operating assets > operating liabilities) represent cash outflows because “cash tied up in working capital cannot be used elsewhere in the business and does not earn returns.” ⁶ Decreases in NWC (i.e., operating assets < operating liabilities) represents cash inflows because cash has been freed up from working capital for use elsewhere and for earning returns.
Interpretation of historical Δ NWC requires careful examination of the subject company. An increase in NWC could be due to increased Accounts Receivable (A/R) or inventory balances. Increased A/R might mean that the company’s cash collection processes are inefficient or that some portion of A/R has become uncollectible (i.e., will never become cash). It could also mean that the company is going through a revenue growth spurt, enhanced through increased credit sales.
Increased inventory balances might mean that inventory is not being sold quickly enough or at all. Or it could mean that the company is stockpiling certain critical inventory items in advance of an upcoming shortage. It could also simply mean that, at the measurement period, cash has been spent on stock that has not sold yet but will sell.
It should be noted that the sale of inventory on credit (via A/R) also increases NWC. It replaces inventory, valued at cost, with a receivable, valued at the sale price (cost + profit). It should also be noted that increased cash flows are the short-term effect of a deliberate reduction of NWC to remove inefficiencies. However, once inefficiencies are removed, the effect of reduced NWC can be diminished or halted revenue growth.
Failure to understand the reasons behind Δ NWC may lead to misinterpretation of company risk or misadjustment of forecasted cash flows.
Review: Ratio Analysis
The following table provides the most common working capital metrics. These ratios, especially the cash conversion cycle, provide insight into the intersection of NWC and cash. ⁷
In addition, the Current Ratio (Current Assets ÷ Current Liabilities) and Quick Ratio (Cash + Marketable Securities + A/R) ÷ Current Liabilities) provide snapshots of company liquidity risk.
Forecasting Net Working Capital Needs
Historical Δ NWC can be volatile, exhibiting large swings between increases and decreases from year to year. Thus, it may not be a reliable benchmark for forecasting. However, there are techniques and methods available to address the forecasting challenge. Several of these are discussed here along with the questions that arise from their use.
Techniques Developing Correlation Between Δ NWC and Revenue Growth
The terms NWC and non-cash working capital are identical.⁸
1. Use the Δ NWC for the most recent year. Grow that change at the same rate as earnings are expected to grow in the future. This is probably the least desirable option because changes in non-cash working capital from year to year are extremely volatile and the most recent year’s change may in fact be an outlier.
2. Base forecasted Δ NWC on non-cash working capital as a percent of revenues in the most recent year and expected revenue growth in future years. This is a much better option than the first one, but the non-cash working capital as a percent of revenues can also change from one year to the next and the most recent year may be an outlier.
3. Base forecasted Δ NWC on the marginal non-cash working capital as a percent of revenues in the most recent year and expected revenue growth in future years. Marginal non-cash working capital is computed by dividing the Δ NWC in the most recent year into the change in revenues in the most recent year. This approach is best used for firms whose business is changing and where growth is occurring in areas different from the past.
4. Base forecasted Δ NWC on non-cash working capital as a percent of revenues averaged over a historical period. The advantage of this approach is that it smooths out year-to-year shifts. However, it may not be appropriate if there is a discernable trend (upwards or downwards) in NWC over the period.
5. Ignore the working capital history of the firm and base forecasted Δ NWC on the industry average non-cash working capital as a percent of revenues. This approach is most appropriate when historical NWC is volatile and unpredictable. It is also the best way of estimating non-cash working capital for very small firms that may see economies of scale as they grow.
The following table provides a summary of technique results, using data from a publicly-traded retailer and a 10% growth rate in revenues over the forecast period. All dollar figures are in millions.⁹
No matter which technique we use, we have just developed forecasts of future NWC and Δ NWC that are correlated to revenue growth. As stated earlier, increases in NWC create cash outflows (i.e., deductions from cash flows) because they represent cash that is now tied up in working capital and no longer available for other uses. So, we will deduct these forecasted NWC increases from Net Income to derive net cash flows. In turn, value decreases.
Additional Methods and Discussion
Under the scenario in which Management chooses to deliberately decrease NWC over one or several forecast years in order to reduce operating inefficiencies, we would need to model NWC forecasts differently. Management’s proposed tactics for efficiency improvement would need to be incorporated into the NWC model. Since decreases in NWC indicate cash inflows, we will add forecasted NWC decreases to Net Income to derive net cash flows. In turn, value increases.
Another scenario might develop in which forecasted increases or decreases in NWC, correlated to revenues or based on Management expectations, fall short of computed working capital requirements. This might require utilising computed working capital requirements for the initial forecast year and applying growth rates for the following years based on discussions with Management.
What if the Δ NWC for a single forecast year or two must reflect Management expectations of unique operating circumstances? Is this already captured in forecasted Net Income? How should the remainder of the NWC forecast be developed?
Should We Forecast NWC Components Separately?
Damodaran asks, “Is there a payoff to estimating individual items such as accounts receivable, inventory and accounts payable separately?” ¹⁰ The answer is, it “will depend upon both the firm being analysed and how far into the future working capital is being projected. For firms where inventory and accounts receivable behave in very different ways as revenues grow, it clearly makes sense to break down into detail. However, the payoff to breaking working capital down into individual items will become smaller as we go further into the future.” ¹¹
The Critical Effect of Time on Forecast Choices
Finally, I suggest that the period over which we utilize any of these techniques or methods becomes an important consideration.
For example, do techniques that increase NWC in sync with revenue growth but decrease value year over year reach a point where they no longer fairly represent the necessary role of Δ NWC in growth? Are there circumstances in which a subject has sufficient NWC built into Net Income and no longer requires it to grow? Should we extend any NWC increases into the perpetual terminal period? Why or why not?
At what point do we stop decreasing NWC for the sake of efficiency because it begins to increase risk and diminish value? Is the cash released via decreases in NWC actually available to distribute to investor/owners or does it need to remain in the company to address future operating liabilities? Should we ever extend NWC decreases into the perpetual terminal period? Why or why not?
What about Common Sense?
The reasonableness test of common sense applies to the use, interpretation, and defense of NWC forecasting techniques and methods. For example, an industry-based technique that yields an annual increase in NWC of $3,000 for a growth company with $25MM in current revenues may indicate that we question either the technique selected and/or the forecast inputs.
Common sense also constrains the use of detailed models for subjects whose size and/or historical performance do not lend themselves to anything but abbreviated financial analysis such as the capitalization of net cash flow (CCF) method. That said, working capital adjustments are made in a CCF and it is not necessarily appropriate to apply a formulaic technique to NWC without having performed at least a superficial inspection of the factors that are influencing NWC and Δ NWC for the subject.
Tying It All Together
As we analyse Net Income to develop net cash flow available to investors/owners, we consider changes in Capex, the effects of taxation, and the existence of non-cash items (such as depreciation). We also consider the effects of interest-bearing debt. Owing to the substantial influence these can have on value, we create and use detailed forecasting models for each.
If Δ NWC represents an inflow or outflow of operating cash, then I suggest we consider performing NWC forecasts with as much detail and rigor as we apply to Capex, interest-bearing debt, non-cash items, and taxation. This will require thorough understanding of the subject’s operating model, its business cycle, its cash conversion cycle, its working capital requirements, and the other factors that influence reasonable estimates of future NWC.
The questions we have posed and the trends and implications we have discussed seem to indicate the following conclusions.
1. Details matter: NWC adjustments to net cash flows should be forecasted explicitly in a separate analysis, supported by ratio analysis, comparability tests, and detailed footnotes regarding underlying rationale.
2. Time matters: Shifts in NWC strategy and needs should be considered by forecast year and for the perpetual terminal period separately rather than applied in a once-for-all manner.
3. Common sense matters: Forecast results should be reviewed for reasonableness and common sense rather than assumed appropriate because a particular formula has been used.
While practical applications stemming from this changed attitude toward Δ NWC are still being developed, readers are urged to begin considering the aforementioned issues seriously. In doing so, we will be able to move beyond standard practice and its casual approach to working capital into more robust valuation analysis and better client service.
