Introduction

Forecasting operating requirements is important in capital budgeting and value-based management. One of the fundamental decisions that every business needs to make is to assess where to invest its funds (capital budgeting) and to reevaluate, at regular intervals, the quality and risk of its existing investments (project management). Investment theory specifies that firms should invest in assets only if they expect them to earn more than their risk-adjusted hurdle rates (Brigham and Davies, 2002; Damodaran, 2001). Forecasting operating capital requirements is a necessary step in estimating the return on projects.

Value-based management is a tool used by management, in which the value of the firm is estimated according to alternative strategies (Copeland et. al., 2000). Estimating operating requirements is essential in this process. Useful as a guide in decision-making, value-based management is also useful for projecting future financing needs, especially companies whose needs are changing.

Similar to the style used in a recent paper I co-published on the computing the cost of equity, the focus of this paper is to illustrate the procedure for forecasting the operating requirements for a high growth firm. There is very little literature that addresses simple procedures for valuing growth companies. The focus of this paper and the contribution to the literature is a simple, but detailed, step-by-step procedure for forecasting operating capital requirements for a growth company, using industry averages. See Beneda for a discussion of the performance of growth companies.

An example of the technique for Community Health Systems, Inc. is used as an illustration. With a growth rate for the year 2002 of 85% and a five-year projected growth rate of 25%, accurate projections for operating capital requirements is essential for Community Health Systems, Inc. (These projected growth rates were obtained from yahoo.finance.com.) The company has a three-year historical sales growth rate of 25.6%, calculated from its financial statements obtained from Compustat. The company was also reported as one of the 40 fastest growing companies by Fortune Magazine in August 12, 2002 issue of Fortune Magazine. A relatively small company, having gone public on June 9, 2000, the company is relatively small with a debt plus market value of equity of $3,334 million, as of December 31, 2001. The application presented would be especially useful in capital budgeting and project management of growth firms.

Why Use Industry Averages?

Two components go into estimating investment in operating capital. The first is net capital expenditures (capital expenditures less depreciation and amortization). Net capital expenditures represent the investment in the long-term operating assets (such as property, plant and equipment, and intangible assets) less the increase in long-term operating liabilities. Depreciation and amortization is subtracted from this amount so that replacement of existing assets is excluded from the computation.

The second is investment in operating working capital. Investment in operating working capital is the increase in operating current assets (cash, accounts receivables, inventories, and prepaids) less the increase in current operating liabilities (accounts payables and accruals).

While one can estimate operating capital requirements for any one year by a simple examination of the financial statements, estimating the expected future needs can be problematic. This is especially true for growth firms. Capital expenditures can fluctuate, as is the case when a new product is introduced or a new plant is built. Consequently, one should examine industry averages and look at capital expenditures over time.

Again, changes in operating working capital can be unstable, with big increases in some years followed by big decreases in the following years. To compensate, the operating capital requirement should be estimated as a percent of revenues, to estimate changes in working capital over time. This technique should be used in conjunction with expected revenue changes each period. Working capital as a percent of revenues can be obtained by looking at the firm's history or at industry norms.