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
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 Disadvantage
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.
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.