# Changes in Working Capital in Free Cash Flow FCF

Written by

Jae Jun

What You Will Learn

• Why including working capital is not needed in FCF calculations
• How to calculate FCF to determine true profitability

There are many variations of free cash flow but recently I’ve been asked a couple of times why I don’t include changes in working capital. So let me go through why I don’t believe including changes to working capital is necessary to the free cash flow calculation or for stock valuation for that matter.

But first, a discussion on working capital..

#### Working Capital and Changes in Working Capital

By definition:

working capital = current assets – current liabilities

Working capital is useful to show the operating liquidity of a company and how the company manages its business.

When we look at the assets of the balance sheet, accounts receivables is listed under assets but when you start thinking about working capital it should actually be under the liabilities section.

The reason why it should be considered as a liability is that the amount of accounts receivables is really just an interest free loan to the customer. The company has not received the cash for the bills. It is only when accounts receivables decreases that cash flow increases. This is what the term “changes in working capital” refers to. The working capital change on the balance sheet impacts the cash flow statement.

For more information, I’ve explained this phenomenon in the analysis of cash flow statements.

Inventory is another major component of working capital and can also be considered to be a liability while accounts payable will add to positive cash flow because it’s money that you owe but haven’t paid yet. So it’s like an interest free loan that increases your cash flow.

#### Working Capital and Free Cash Flow

So people ask me why I don’t include changes in working capital to the FCF equation in the stock analysis tools because clearly accounts receivables does not represent an increase in cash. Inventory also doesn’t bring in cash if it is sitting on the shelf.

#### Warren Buffett’s FCF: Owner Earnings

The formula I use for FCF is Buffett’s definition of FCF, a.k.a. owner earnings. Do take the time to read the appendix of the 1986 Berkshire letter to shareholders as it explains owner earnings in depth.

Owner earnings = Net income + depreciation & amortization +/- one-time items +/- changes in working capital – capital expenditures

“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

So if changes in working capital is really that important, why doesn’t Buffett use it?

Was it a) because the term never existed in 1986? b) or did he just forget about it?

I believe it is neither.

If you note the bolded section of Buffett’s owner earnings, he clearly states that changes in working capital should also be in (c). That is, if a company is required to increase working capital in order to maintain its position and operations, that’s really an increase of maintenance capex.

Also, since I haven’t found a single person who can accurately judge or calculate maintenance capex, I just use the total capex in the stock value calculators which will more than cover the working capital required for maintenance.

#### Purpose of Free Cash Flow

The way I see it, modern corporate finance has had a lot of influence on the FCF definitions. The part that I feel most people confuse is that by including changes in working capital, it is actually calculating the amount of cash left over for shareholders at the end of the year period.

But as an investor, what exactly are you trying to measure? The amount of money that is available in the business? Or the true profitability?

That’s the key that most investors forget. We use FCF in a discounted cash flow valuation, not to measure how much money is left over for us, but to find the true profitability of the company and the rate of growth at which it can increase those profits.

This is exactly why I believe Buffett calls his modified FCF formula as owner earnings. The true earnings of a company. He publicized the formula to combat the non-effective and rather misleading EBITDA definition of profitability and cash flow.

The Buffett style of investing I’ve read in countless books all mention one thing – he looks for great ongoing businesses with competitive advantages, not how much a company can give out at the end of the year.

Working capital also has it own set of disadvantages.

Current assets and liabilities are fairly easy to manipulate and depending on the accounting method, the amount will vary by considerable amounts. E.g. a company using the LIFO method will have a much lower inventory value compared to a company that uses the FIFO method to value inventory. The two companies could have exactly the same set of products in their warehouses, but just depending on whether they use a conservative or aggressive accounting, it will make a big differences.

Working capital can also vary drastically year to year which could provide an inaccurate picture of the business as well as affect the projected growth rate.

But there is no right or wrong. It just depends on how you view a business and investment.

#### Summary

To sum things up, I simply exclude changes in working capital because my point of view is that I am looking for the true profitability of the company which is why I stick with Buffett’s owner earnings.

• Ben

Hello Jae Jun,

I don’t really follow your explanation of accounts receivable…If they increase, it means working capital increases which is a drain on your cash…and hence gets deducted from free cash flow in “classic” FCF calculations. Your post seems to indicate otherwise.

Hence if a business is increasing payables and/or inventory due to growth or market competition or whatever, it should be discounted from cash flow as it is a business expense that you ‘have to incur’ (assuming management is doing its best). Thus even as a business owner and not ‘just’ a stockholer this use of cash is very real and impacts the cash that is left for owners after running normal business expenses.

This usually does not make a large difference for most stable businesses and hence – if you take a good margin of safety – should not change your view on investing in a business. But it may be a good thing to track for businesses that are growing fast as well as those in a downturn which need to keep increasing payables/inventories.

Cheers,
Ben

• slinj

Jae, as always, very well written essay.
In the same line of business, when company A is compared to company B, an in-depth analysis of working capital might be of help.
FCF would be universal though across businesses.

• http://www.oldschoolvalue.com Jae Jun

@ Ben,
Yeah my wording may be confusing. You are right that working capital will go up if accounts receivables goes up but I was referring more in terms of cash flow. If accounts receivables increases, it doesn’t mean that cash position has gone up. You’ve sold a service and you are waiting for a payment without interest from your customers. This is what I meant as accounts receivables being like a liability.

Although I agree that using cash to increase inventory, and other assets is a real business expense, I see it nothing more than measuring the short term liquidity of a business. It doesn’t add any affects to profitability and earnings power of the business at all.

If the balance sheet revealed increases in inventories and accounts receivables, it is a major warning sign right away and I probably wouldn’t even work my way down to the FCF line.
So while I understand why people want to include changes in working capital, I don’t believe it serves the purpose of providing a proper view of the business profitability. I mean, just by seeing the trend of receivables and payables and doing an analysis of inventory will reveal most things.

@ slinj,
Yup just doing the routine cash flow statement analysis and looking at receivables, payables, inventory and other liabilities should help even more.

• Greg Goodale

I believe the answer as to why we (and Buffet) don’t include changes in working capital in the determination of FCF for a given year is because we are trying to determine the amount of free cash flow that is generated by current year earnings or operations. For instance, if we didn’t ignore changes in working capital, then, as an example, lets say a company had sales in Year 1 of \$1000 but didn’t receive the cash until Year 2 (I.E. the \$1000 is in Accounts Receivable at the end of Y1), then the \$1,000 of sales in Y1 would show up in the FCF number in Y2 even though it was Y1 operations that generated the cash flow. Further, inventory acquired in Y1 but sold in Y2, would reduce FCF in Y1, while Y2 would get the benefit of cash flow from the inventory. If we didn’t remove changes in working capital in the determination of FCF, you can see how this would distort the true results of operations for that specific period.

• Ryan B

You have to tread carefully with this. For example, if you see a substantial increase in accounts receivable or inventory compared to prior years, you would most likely be doing yourself a disservice by not including the increase in your calculation.

Rather or not the calculation of FCF is to determine how much a business generates in cash or simply the profitability of the business, I am not really sure. I think it is both. I did and I continue to regularly read the 1986 letter to shareholders which adds to my confusion. He has said countless times that the value of a company is how much cash a business can generate. If the company increases it sales, but of instead of increasing the cash position, the a/rs increase, the company has not yet generated more cash because there is still the possibility that it may not collect on the receivables. My thinking is to be conservative and to wait until cash is actually received and thus deduct a/r and etc.

But I can see the argument for both sides and I am probably off base here.

• http://www.oldschoolvalue.com Jae Jun

Thanks for your input Greg and Ryan.

I guess this is another part of the art involved in valuation. Both you guys have valid points and I don’t believe there is a right or wrong.

But at least now that I have my side of the argument down in writing, people will see why I don’t include it in the spreadsheets.

• http://narejo.com Abdul Rasheed Narejo

“The reason why it should be considered as a liability is that the amount of accounts receivables is really just an interest free loan to the customer.”
An interest free loan of less than 1 year to customers will still be categorized as current assets and not current liabilities. Please learn basic accounting before commenting on valuation.

I thinking there is more pratical reason why change in working capital should not be adjusted in FCF formula. Of all the FCF items, WC Is most volatile and unpredictable item as per my experience. WC changes have far greater impact on FCF than any other item and often these changes are only temporary. In order to arrive at a more predictable FCF it is better to calculate FCF without WC changes.

• http://www.oldschoolvalue.com Jae Jun

@ Abdul,

As you state, I may not know basic accounting but if you read the context and not just the sentence you would have realized I was talking about how WC affects cashflow.

If you give me a loan of \$1,000,000 for 1 year, you’re out of that money from your pocket. From a cash flow point of view, how is that assets?

Balance sheet, yes, but cash flow, no.

I do agree with your reason for not include WC which I also included.
“Working capital can also vary drastically year to year which could provide an inaccurate picture of the business as well as affect the projected growth rate.”

• Ben

Here’s a video of mr. mason hawkins, mba, southeast asset management definition of FCF or Owner Earnings http://www.bengrahaminvesting.ca/Resources/Video_Presentations/Hawkins.htm

• valueinvestortoday

I haven’t read the responses so I don’t know if this has already been addressed. I believe the “wording” Buffett uses is confusing to a degree and that what he said can be interpreted this way: “If the business requires additional working capital to maintain its competitive position and unit volume, the ANALYST SHOULD INCLUDE THE increment in (c).”

Capital Expenditures consist of PPE. E doesn’t equal inventories and receivables. Maintenance CapEX, which is apart of the overall CapEX, doesn’t include receivables and inventories either. Receivables and Inventories are a necessary expenditure that require the use of cash and should be accounted for if you’re sure that, in regards to inventories, the units have increased rather than just the LIFO value which can fluctuate the book value of unchanged units of inventory.

This is what I believe Buffett was saying. The way he worded, however, made it difficult to comprehend without some serious thought of the matter and you never know, my ideas could be complete hog wash as well.

• valueinvestortoday

Let me add an indifference to this subject as well. Many very good analysts recommend expensing changes in working capital. Hewitt Heiserman, Jr. from “It’s Earnings That Count”, a book I recently finished reading. His argument is that it’s a “use of cash”. My argument is that any increase in receivables is “not a use of cash”. Prepaid expenses and Inventories are truly the only additional use of cash and nearly 100% of the time prepaid expenses are recovered rather quickly. Therefore, we’re really left with inventories as being a use of cash. If our working capital looked like this (incidentally, cash & equivalents are not apart of the equation):

Receivables Current Period: \$120
Receivables Previous Period: \$100
Inventory CP: \$75
Inventory PP: \$75
Prepaid CP: \$10
Prepaid PP: \$10
Current Liabilities: \$50
Previous Liabilities: \$50

The result is an increase in working capital, which Heiserman and others consider a use of capital, of \$20. Therefore, we’d make an expense for that amount to signify we used an additional \$20 of capital over last period. This is not entirely correct. We did ship products valued at that amount to our customer and awaiting payment but we didn’t necessarily poor additional capital into the receivables chain in the same regard if the increase would have taken place in inventories. But, there is an opportunity cost of capital in regards to those receivables that we are awaiting payment on. Further research on that subject matter is in process. If the above scenario (\$20) was in regards to inventories, I think there’s no question that an accounting of that item should be included in overall capital expenditures. But the more important thing to take notice of, in my opinion, isn’t so much whether working capital has increased or not, but the balance or imbalance of receivables and inventories which is far more important than possibly squeezing a few more pennies per share of EPS.

• valueinvestortoday

One last thing to mention (sorry for my long windedness as always). If current liabilities are reduced from one period to the next, that also lends significant weight to how our working capital scenario plays out. Any payment of debt can be found on the cash flow statement and accounted for in that regard. If we do so in that fashion, and recognize that any increase in receivables isn’t a use of cash, then all we’d simply need to do is account for inventories from one period to the next.

• http://www.oldschoolvalue.com Jae Jun

Thanks for your opinion. I agree with a lot of what you said and it’s been addressed in the comments as well.
It isn’t important to include changes in working capital because it isn’t a “use of cash” as Heiserman puts it.
But inventory should be considered cash as it takes real money for inventory to increase or decrease which you can identify from the cash flow statement anyways.
What it boils down to is that owner earnings provides the true picture of the company’s operations at a given time better than FCF.
I like to compare both as I don’t like it when there are huge differences but for the most part, owner earnings growth is what leads to the intrinsic value growth.

• Mark

What if there is actually a decrease in receivables and inventories, it does mean higher free cash flow right? Are the increases in FCF that resulted from the decrease in receivables and inventories also discounted in the same token as any decrease in FCF caused by increases in these two items are excluded?

• http://www.oldschoolvalue.com Jae Jun

There are two ways to calculation FCF. The standard FCF = Cash from Operations – Capex or the Owner earnings variation. The standard formula accounts for changes in working capital. The owner earnings version usually does not. To answer your question, choose a version that makes sense to you and be consistent. Analyze the company and make sure the FCF method makes sense.

• Matthew

Great value articles and FCF info. Really like your blog.

• Gregory

I like Buffet’s owner earnings, they were a relief when I read about them.
I always asked myself how in heaven does it make sense to include working capital in cash flows.. no one truly convinced me of this practice so far.

Similiarly the overall FCF (net sum from all three sections) number is just not that useful, I completely agree with you.
Why? Just check your bank account on online banking, put the individual entries into excel for the last few months. These numbers we all know in and out. You know if you were frugal and saved every penny, or if you spent money on everything thats nice and shiny.
So what does the overall change in your cash account from your personal balance show… inflow =x,000, outflow = x,000? so what does that tell me on how much im spending? nothing. It suddenly does start to make sense when the individual accounts are categorized (transport costs, rent costs etc etc)and the long-term or one-off things are excluded. That’s close to the income statement though. So income statement is roughly fine except for a few points, certainly better then FCF I+FCF O+FCF F. if the sum of everything does not even give a clear picture for an individual person, it certainly won’t for a large corporation.

However..
!!! Why would you include all the Capex… Warren Buffett means maintenance capex! That’s a number one has to find out for oneself..but that’s good! You will agree, those sort of things are the whole fun of analyzing.. going beyong capital iq and bloomberg : )

If you earned 40 k last year after deducting all expenses. you also bought a house for 200k that year too… you cant say I made -160 k last year you see.
The capex is an investment (might be a lousy one, so have unforeseeable investment risk like an investment in an investment, so many investors dont like huge growth capex, instead prefer (ideally) something close to a safe cashcow at a discount for whatever reason).
It has a salvage value… it is expected to create future cash flows..
so it does not belong in THIS period and it is not an expense. Take it out!
doing what you do, doesn’t kill, it will simply automatically select only companies with minimal capex requirements. I would rather do a seperate analysis on this.

Some companies are very stable yet growth capex intensive. if a company builds great trucks with a great growing customer basis, and builds a new plant, dont see a problem with that. So I prefer to know how much was invested, and how? is it a safe investment?

Now lets look at another capex. Say lets say someone has a house and rents it out.
if he spends money (equity or debt) to repair something, install some energy meter… that doesn’t create value, it won’t increase the value of the house through future rents. It only maintains the house and keeps the tennants happy. So it’s maintenance capex, and an expense indeed.

In contrast, if one expands the house on the roof with nice balconies and 3 extra appartments… that’s essentially like buying an extra house. It’s growth capex, and not a pure expense, so I wouldn’t deduct it from earnings. Growth capex will probably also be financed mostly through debt and not through money which the business earns in that period.. hence income will be continuous and expenses also (interest+principal). deducting the whole thing from one period seems “unfair” to the company :D. Afterall, you didn’t include the financing they took (usually loan or bond) for realizing the project. Let’s also not forget the company tries to estimate capex numbers generous, so they can depreciate as much as possible.

Maintenance capex will probably in most cases be paid off with money generated quite recently. Some companies might even capitalize things which are not really capex, to improve net profit, an accounting trick. Wiki: “Capital expenditures (CAPEX or capex) are expenditures creating future benefits” so we’re looking for “unreal” capex, which we as shareholders would rather regard as simply an extra cost to add to the income account.

• Dzulhaziq

Hello,

i’m very very new at this. hope u can help out.

i do not have any strong educational background on finance or accounting, so most of the time i get confused with some of the financial formulas. So, i hope u would understand how little knowledge i have, but i’m still learning

i have just finished reading “Fundamental Analysis for Dummies”, but the book doesn’t provide FCF formula.

only today i found out about “Owners Earnings” aka FCF, and because Warren Buffet is using it, i would too.

i’m currently making a personal excel spreadsheet. My purpose is because i want to have a deeper understanding of its formulas, its explanation, how to extract information from financial reports.

i want to start from the bottom/basic.

Now, back to my question and Its about capital expenditure.

1. Is it previous year (TA-TL) minus current year (TA-TL)or the other way around.

2. is it suppose to be just a positive number? because, if its negative and i put it in the Owner earnings formula it would become positive.

i tried to google it, but it seems that most of the people in most forums are quite advanced. so, its not discuss whether its supposed to be +ve or -ve.