Analyzing an investment before jumping in laborious, yet crucial, step. Figuring out how much a company is worth is an essential step to figuring out if the price paid to invest in it is good or bad. Net present value (NPV) is one key component to get a handle on, and yes, working capital is included in that calculation. Working capital measures a company's efficiency and its ability to meet near-term obligations.
What Is Net Present Value?
Net present value is the difference between the present value of the incoming cash flows and the present value of the outgoing cash flows. It indicates the current value of a company based on its projected earnings less projected expenses. A positive NPV indicates a profitable investment, while a negative NPV indicates a loss-producing investment. Changes in working capital are an integral component in calculating net cash flow.
NPV is frequently used for budgeting, accounting, and investment analysis purposes. It is based on the assumption that money today is worth more than money in the future. This is due to assumed inflation and opportunity cost from not having the money in the meantime. To account for this, analysts often apply a discount rate when calculating the value of money in the future. Sometimes the expected return from lost investment opportunities can be used to calculate the discount rate used to value future cash.
Using NPV to value investments has its advantages, but there are drawbacks, as well. NPV calculation relies heavily on assumptions and estimates. Several factors could affect the future value of an investment that are not predicted by the model. The longer the time frame of the investment, the more risk there is of this. Internal rate of return (IRR) is a similar metric to NPV but uses a discount rate that reduces the NPV to zero, thus attempting to make investments comparable, even if they have different time frames.
What Is Working Capital?
Working capital is the difference between a company's current assets and its current liabilities. Current assets can include things like cash, accounts receivable and inventories. Current liabilities can include things like accounts payable, or money owed. Working capital is calculated by simply subtracting current liabilities from current assets.
The most prominent current liability is accounts payable, or money owed to suppliers by the company for goods or services already received. The most prominent current asset is accounts receivable, or money owed to the company from customers who have received, but not paid for, their orders.
Changes in these working capital accounts work to either increase or decrease cash flow. Cash flow increases as accounts receivables decrease or as accounts payables increase. Accordingly, cash flow decreases as accounts receivables increase or accounts payables decrease. Therefore, as working capital changes from period to period, it has an effect on cash flow which, in turn, has an effect on NPV.
Working capital is a measure of both a company's short-term financial health and its operational efficiency.