What? Does the value of business goodwill change depending on the amount of current liabilities carried by the company?
It may not sound intuitive, but it actually is true. Consider the well known capitalized excess earnings business valuation method, the go to technique when valuing business goodwill.
A trick question: how much capital is committed to the business operations?
If you take a close look at how this method works, you will notice that the net asset value is calculated as the difference between the adjusted business assets less its current liabilities. This net asset value is then multiplied by the fair rate of return to estimate the capital charge, or the amount due on the committed business capital. The greater the net asset value, the higher the capital charge.
Excess earnings – what’s left after return on committed capital
Now for the fun part. The capital charge is next subtracted from the business earnings basis in order to calculate the excess earnings. This quantity gives the method its name. The idea is that a well run business generates earnings in excess of the capital charge thus providing superior return on investment.
Higher excess earnings indicate higher business goodwill
The capitalized excess earnings method determines the value of business goodwill by capitalizing these excess earnings. So the higher the excess earnings, the greater the business goodwill value. Businesses that put more money into the owners’ pockets are associated with higher business goodwill.
Notice that the capital charge is affected by both the total business asset values as well as the current liabilities. Given the asset values, higher current liabilities result in a lower net asset value and smaller capital charge. This in turn leads to higher excess earnings and increases the amount of business goodwill.
That’s how the capitalized excess earnings valuation method works. But what does it tell you in pure economic terms?
Higher earnings with less capital required often result in higher business goodwill
It essentially implies that those businesses able to operate on lower net asset bases have higher goodwill. These companies use Other People’s Money very effectively to finance their operations, usually in the form of short term borrowing from their suppliers.
The secret behind e-commerce success – lower working capital requirements
An example would be an e-commerce online retailer that gets paid shortly after selling the products. At the same time, the company enjoys attractive short term financing terms from its vendors. In addition, it reduces the need for working capital by managing its inventory just in time. The result is lower inventory shrinkage, more economic reordering strategy, and less capital tied up to meet the sales goals.
This is one reason online businesses are often able to out-compete their brick-and-mortar competitors. The online companies do not require expensive real estate for merchandizing and can manage their inventory and other direct selling costs more flexibly. Online businesses tend to focus on efficient and cost effective order fulfillment without the extra overhead of a retail store presence in a high priced shopping mall.