How Changes in Working Capital is Used


There are far too many grey areas of investing. Working capital falls into this area.
Working capital is simply a fancy word for how and where money is spent for day to day operations, and the change in working capital is simply the difference in working capital between two periods.
The math is basic, but there is more to think about beyond subtracting current liabilities from current assets.


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Jae Jun

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Update: A new and complete guide to changes in working capital has been published which details every piece of this topic.

There are far too many grey areas in investing. Changes in working capital is one of them.

In its simplest and purest form, working capital from the balance sheet is just

Working Capital = Current Assets – Current liabilities

Working capital is simply a fancy word for how and where money is spent  for day-to-day operations, but the change in working capital is the deeper discussion of understanding the flow of cash and the impact it has due to the requirements of business operations. It’s not just the difference. That is simplifying it too much and will lead to errors in your calculation because you first need to understand the core concept.

Changes in Working Capital
= Previous Working Capital – New Working Capital

= (Previous Current Assets – Previous Current Liabilities)
- (New Current Assets – New Current Liabilities) 

= (Previous Current Assets – New Current Assets)
+ (New Current Liabilities – Previous Current Liabilities)

The math is basic, but there is more to think about beyond just subtracting current liabilities from current assets.

What Causes a Change in Working Capital?

Here are some examples of how working capital works in the real world.

If an owner of a business makes an investment of $100k into his company, current assets increases by $100k without any increase in current liabilities.

Therefore, working capital has increased by $100k.

If an asset increases:

  • change in working capital is negative
  • actual working capital increases
  • cash flow is reduced
  • subtract the change from cash flows for owner earnings

i.e. Asset increase = spending cash = reducing cash = negative change in working capital

What I’m getting at here is that when you think in terms of the change in working capital, you only consider the working capital items that are related to the business operations.

Cash and debt should be ignored as it doesn’t affect the business operations. Even if  you get a loan from the bank of $100, your cash balance increases by $100 and your debt increases by $100. This cancels each other out. So even from an accounting point of view, it balances and can be ignored when thinking about the entire picture of changes in working capital.

But let’s say accounts payables increases by $500k, what happens to the change in working capital?

If liability increases:

  • change in working capital is positive
  • actual working capital decreases
  • cash flow is increased
  • add the change to cash flow for owner earnings

i.e. Liability increase = owing something = not spending cash upfront = increase in cash = positive change in working capital

Change in Working Capital is a cash flow item and it is always better and easier to use the numbers from the cash flow statement as I showed above in the screenshot.

The “change” refers to how the cash flow has changed based on the working capital changes. You have to think and link what happens to cash flow when an asset or liability increases.

If current assets is increasing, cash is being used.

If current liabilities part is increasing, less cash is being used as the company is stretching out payments or getting money upfront before the service is provided.

To tie this together, the “change” is about determining whether current operating assets or current operating liabilities is increasing.

If the final value for Change in Working Capital is negative, that means that the change in the current operating assets has increased higher than the current operating liabilities.

If Changes in Working Capital is positive, the change in current operating liabilities has increased more than the current assets part.

Put another way, if changes in working capital is negative, the company needs more capital to grow, and therefore working capital (not the “change”) is actually increasing.

If change in working capital is positive, the company can grow with less capital because it is delaying payments or getting the money upfront. Therefore working capital is decreasing.

These two last sentences is also the key to calculating owner earnings properly and understanding how to do a better DCF.

How is Working Capital used in Valuation?

I would have to say the correct question would be “how are changes in working capital used in valuation?”.

This links to the subject of the Discounted Cash Flow (DCF) valuation method.

Working capital (CA – CL) alone is just a single point in time data and is difficult to put into perspective. It doesn’t give you insight into the business.

That’s why you want to use the change in working capital.

Now there are two ways to use changes in working capital to arrive at a FCF number for a DCF valuation.

  1. include it, or
  2. exclude it

There are two options, because it has to be done on a case by case basis. If you just straight to the calculations and formula, you will mess it up.

If you want the simple version, stick with the standard FCF definition:

FCF = Net Cash from Operations – Capital Expenditure

If you take the extra step of determining when to include or exclude changes in working capital, you’ve now arrived at owner earnings.

“If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)” – 1986 Berkshire letter

Here’s the simple version of this block of text:

Owner Earnings =

     (a) Net Income

     + (b) depreciation, amortization

     +/- (b) other non cash charges

     – (c) annual maintenance capex (or the full capex)

    +/- changes in working capital

Even though Buffett mentions “additional working capital”, it does not mean changes in working capital should automatically be added. If the business condition changes where there is a permanent increase in working capital, then yes it should be added.

But Buffett is really talking about the cash flow requirements of the business as I discuss in detail in the guide to changes in working capital.

Rules of Thumb and Summary

The fundamental purpose of even discussing working capital is about cash flow needs of a business. Not the balance sheet calculation.

If an asset increases:

  • change in working capital is negative
  • actual working capital increases
  • cash flow is reduced
  • subtract the change from cash flows for owner earnings

i.e. Asset increase = spending cash = reducing cash = negative change in working capital

If liability increases:

  • change in working capital is positive
  • actual working capital decreases
  • cash flow is increased
  • add the change to cash flow for owner earnings

i.e. Liability increase = owing something = not spending cash upfront = increase in cash = positive change in working capital

  • umer ashraf

    I have been reading your posts for last few weeks. Great Stuff. Have been interested in investing for last few months. I had invested only in one company since 2009 which was apple based on low PE and i was trying to diversify but was’nt sure how to invest more. But since last 1 month i have been reading extensively and had got some grasp on it.

    Sometimes , I see ppl using working capital in addition to earnings or FCF to value a company, meaning adding what FCF shows to working capital? Can you use both and in what situations?

  • I’m not sure I understand. Are you saying that people are adding changes in working capital to FCF? or adding changes in working capital to earnings?

  • Pingback: What is Owner Earnings?()

  • Fabian

    Afaik working capital is not included in owner’s earnings because the latter has no growth component. That is also why the above quote from Buffett mentions maintenance capex instead of capex.

  • djames

    How is this increase in Working Capital a USE of cash?

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