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.
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 – 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.
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.
November 27th, 2009 at 9:21 pm
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
November 28th, 2009 at 9:49 am
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.
November 29th, 2009 at 12:29 am
@ 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.
December 1st, 2009 at 3:14 pm
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.
December 1st, 2009 at 11:01 pm
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.
December 1st, 2009 at 11:09 pm
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.
December 4th, 2009 at 11:47 pm
“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.
December 5th, 2009 at 1:47 am
@ 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.”
January 29th, 2010 at 12:49 am
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