Comments on: Changes in Working Capital in Free Cash Flow FCF

By: ROE ROIC CROIC Metrics Explained and Analyzed

ROE ROIC CROIC Metrics Explained and Analyzed — Tue, 02 Mar 2010 07:11:58 +0000

[...] course you can use owner earnings instead of FCF. How to Use [...]

By: Ben

Ben — Fri, 29 Jan 2010 07:49:31 +0000

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

By: Jae Jun

Jae Jun — Sat, 05 Dec 2009 08:47:03 +0000

@ 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.”

By: Abdul Rasheed Narejo

Abdul Rasheed Narejo — Sat, 05 Dec 2009 06:47:32 +0000

“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.

By: Jae Jun

Jae Jun — Wed, 02 Dec 2009 06:09:52 +0000

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.

By: Ryan B

Ryan B — Wed, 02 Dec 2009 06:01:26 +0000

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.

By: Greg Goodale

Greg Goodale — Tue, 01 Dec 2009 22:14:43 +0000

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.

By: 2009 Best Small Companies Part 5 | Old School Value

2009 Best Small Companies Part 5 | Old School Value — Mon, 30 Nov 2009 10:06:35 +0000

[...] is very profitable both top and bottom line of the financial statements. Owner earnings has seen massive growth at more than 50% over the past 5 years. CROIC however, is good, but not as [...]

By: Jae Jun

Jae Jun — Sun, 29 Nov 2009 07:29:04 +0000

@ 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.

By: slinj

slinj — Sat, 28 Nov 2009 16:49:41 +0000

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.