Most roads in mergers and acquisitions (M&A) lead to valuation.  Net working capital (NWC) analysis is no different.  NWC impacts valuation in two ways:  the impact on free cash flow (FCF) and in the purchase price adjustment via the NWC mechanism.  

In this post, we will focus on NWC’s impact on FCF.

Net Working Capital directly impacts free cash flow (FCF).  This is made clear via the unlevered FCF equation.

Unlevered Free Cash Flow = EBITDA – CapEx – the Change in NWC

The year-over-year change in Net Working Capital reflects how much cash flow must be invested in the liquidity needed to run and grow the business. If a business is worth the net present value (NPV) of its future free cash flow streams, Net Working Capital’s impact on FCF stands to impact the value of the business.

All else being equal, a business with a lower NWC requirement will increase its free cash flow generation and its value. Understanding a company’s Net Working Capital requirements and Cash Conversion Cycle metrics is necessary for investors to have a fully informed view to forecast a company’s cash flows.