Accounting: Working Capital, Free Cash Flow, and Other Metrics and Ratios Flashcards
What is Free Cash Flow (FCF), and what does it mean if it’s positive and increasing?
There are different types of Free Cash Flow, but one simple definition is Cash Flow from Operations (CFO) minus CapEx.
FCF represents a company’s “discretionary cash flow” – how much cash flow it generates from its core business after also paying for the cost of its funding sources, such as interest on Debt.
It’s defined this way because most items in CFO are required to run the business, while most of the CFI and CFF sections are optional or non-recurring (except for CapEx).
It’s generally a good sign if FCF is positive and increasing, as long as it’s driven by the company’s sales, market share, and margins growing (rather than creative cost-cutting or reduced reinvestment into the business).
Positive and growing FCF means the company doesn’t need outside funding sources to stay afloat, and it could spend its cash flow in different ways: hiring more employees, re-investing in the business, acquiring other companies, or returning money to the shareholders with Dividends or Stock Repurchases.
What does FCF mean if it’s negative or decreasing?
You have to find out why FCF is negative or decreasing first. For example, if FCF is negative because CapEx in one year was unusually high, but it’s expected to return to normal levels in the future, negative FCF in one year doesn’t mean much.
On the other hand, if FCF is negative because the company’s sales and operating income have been declining each year, then the business is in trouble.
If FCF decreases to the point where the company runs low on Cash, it will have to raise Equity or Debt funding ASAP and restructure to continue operating.
Short periods of negative FCF, such as for early-stage startups, are acceptable, but if a company continues to generate negative cash flow for years or decades, stay away!
Why might you have to adjust the calculation for FCF if you’re analyzing a company that follows IFRS rather than U.S. GAAP?
The simple definition (Cash Flow from Operations minus CapEx) assumes that Cash Flow from Operations has deductions for the Net Interest Expense, Preferred Dividends (if applicable), Taxes, and all Lease Expenses.
That is almost always the case under U.S. GAAP because CFO usually starts with Net Income (to Common), but under IFRS, the presentation of the Cash Flow Statement varies widely.
So, if a company starts CFO with Operating Income or Pre-Tax Income instead, you’ll have to make adjustments to ensure that the proper items have been deducted.
Also, you should not add back the Depreciation element of the Lease Expense in the non-cash adjustments section of CFO.
What is Working Capital?
The official definition of Working Capital is “Current Assets minus Current Liabilities,” but the more useful definition is:
Working Capital = Current Operational Assets – Current Operational Liabilities
“Operational” means that you exclude items such as Cash, Investments, and Debt that are related to the company’s capital structure, not its core business.
This version is sometimes called Operating Working Capital instead.
You may also include Long-Term Assets and Liabilities that are related to the company’s business operations (Long-Term Deferred Revenue is a good example).
Working Capital tells you whether a company needs more in Operational Assets or Operational Liabilities to run its business, and how big the difference is. But the Change in Working Capital (see below) matters far more for valuation purposes.
A company has negative Working Capital. Is that “good” or “bad”?
It depends on why the Working Capital is negative because different components mean different things.
For example, if the company has $100 in Accounts Receivable, $100 in Inventory, and $500 in Deferred Revenue, for ($300) in Working Capital, that’s considered positive because the high Deferred Revenue balance means it has collected significant cash before product/service delivery.
But if that company has $100 in AR, $100 in Inventory, and $500 in Accounts Payable, that’s considered negative because it means the company owes a lot of cash to its suppliers and other vendors and collects no cash from customers in advance of deliveries.
Should Changes in Operating Lease Assets and Liabilities be included in the Change in Working Capital? What difference does it make if they are included or not included?
Different companies set up their statements differently, so some companies list these items within the Change in WC, others list them outside of the Change in WC but within Cash Flow from Operations, and others do not list them on the CFS at all.
Under U.S. GAAP, the exact treatment makes almost no difference because the Change in Operating Lease Assets tends to be very close to the Change in Operating Lease Liabilities, so changes to these items usually offset each other.
Under IFRS, only increases in Operating Lease Assets and Liabilities could potentially appear within the Change in Working Capital because the Depreciation and Lease Principal Repayment parts are shown separately.
Even though the Lease Assets and Liabilities decrease by different amounts each year under IFRS, they should increase by about the same amount. Therefore, the cash flows usually offset each other, and these items’ exact positions do not matter.
A company’s Working Capital has increased from $50 to $200.
You calculate the Change in Working Capital by taking the new number and subtracting the old number, so $200 – $50 = positive $150.
But on its Cash Flow Statement, the company records the Change in Working Capital as negative $150. Is the company wrong?
No, the company is correct. On the Cash Flow Statement, the Change in Working Capital equals Old Working Capital – New Working Capital.
Pretend that Working Capital consists of ONLY Inventory. If Inventory increases from $50 to $200, that will reduce the company’s cash flow because it means the company has spent Cash to purchase Inventory.
Therefore, the Change in Inventory should be ($150) on the CFS, and if that’s the only component of Working Capital, the Change in WC should also be ($150).
When a company’s Working Capital INCREASES, the company USES cash to do that; when Working Capital DECREASES, it FREES UP cash.
What does the Change in Working Capital mean?
The Change in Working Capital tells you if the company needs to spend in ADVANCE of its growth, or if it generates more cash flow as a RESULT of its growth.
It’s also a component of Free Cash Flow and gives you an indication of how much “Cash Flow” will differ from Net Income, and in which direction.
For example, the Change in Working Capital is often negative for retailers because they must spend money on Inventory before being able to sell products.
But the Change in Working Capital is often positive for subscription companies that collect cash from customers far in advance because Deferred Revenue increases when they do that, and increases in Deferred Revenue boost cash flow.
The Change in Working Capital increases or decreases Free Cash Flow, which directly affects the company’s valuation.
What does it mean if a company’s FCF is growing, but its Change in Working Capital is more and more negative each year?
It means that the company’s Net Income or non-cash charges are growing by more than its Change in WC is declining, or that its CapEx is becoming less negative by more than the Change in WC is declining.
If a company’s Net Income is growing for legitimate reasons, this is a positive sign. But if higher non-cash charges or artificially reduced CapEx are boosting FCF, both are negative.
In its filings, a company states that EBITDA is a “proxy” for its Cash Flow from Operations. The company’s EBITDA has been positive and growing at 20% for the past three years.
However, the company recently ran low on Cash and filed for bankruptcy. How could this have happened?
Although EBITDA can be a “proxy” for CFO, it is not a perfect representation of a company’s cash flow. Think about all the items that EBITDA excludes, but which affect the company’s Cash balance:
- CapEx – Unnecessarily high CapEx spending might have pushed the company to bankruptcy.
- Acquisitions – Or, maybe the company spent a fortune on companies that turned out to be worthless.
- Interest Expense and Debt Repayment Obligations – A “positive and growing EBITDA” could have hidden a “massively growing Interest Expense.”
- Change in Working Capital – Maybe the company became less efficient in collecting cash from customers, or it had to start paying its suppliers more quickly.
- One-Time Charges – If EBITDA excludes large “one-time” expenses such as legal and restructuring charges, it might paint a far rosier picture than reality.
How do you calculate Return on Invested Capital (ROIC), and what does it tell you?
ROIC is defined as NOPAT / Average Invested Capital, where NOPAT (Net Operating Profit After Taxes) = EBIT * (1 – Tax Rate), and Invested Capital = Equity + Debt + Preferred Stock + Other Long-Term Funding Sources.
It tells you how efficiently a company is using its capital from all sources (both external and internal) to generate operating profits.
Among similar companies, ones with higher ROIC figures should, in theory, be valued more highly because all the investor groups earn more for each $1.00 invested into the company.
What are the advantages and disadvantages of ROE, ROA, and ROIC for measuring company performance?
These metrics all measure how efficiently a company is using its Equity, Assets, or Invested Capital to generate profits, but the nuances are slightly different.
ROE and ROA are both affected by capital structure (the company’s Cash and Debt and Net Interest Expense) because they use Net Income (to Common) in the numerator.
However, they’re also “closer to reality” because Net Income (to Common) is an actual metric that appears on companies’ financial statements and affects the Cash balance.
By contrast, since NOPAT is a hypothetical metric that doesn’t appear on the statements, ROIC is further removed from the company’s Cash position, even though it has the advantage of being capital structure-neutral.
In terms of ROE vs. ROA, ROA tends to be more useful for companies that depend heavily on their Assets to generate Net Income (e.g., banks and insurance firms), while ROE is more of a general-purpose metric that applies to many industries.
A company seems to be boosting its ROE artificially by using leverage to fuel its growth. Which metrics or ratios could you look at to see if this is true?
Companies can artificially boost their ROE by continually issuing Debt rather than Equity because Debt doesn’t affect the denominator, and the Interest Expense from Debt only makes a small impact on the numerator (Net Income).
And this small impact is usually outweighed by the additional Operating Income the company generates from the assets it buys with the proceeds from the Debt issuances.
To see if this is happening, you could check the company’s Debt / EBITDA and EBITDA / Interest ratios and see how they’ve been trending. If Debt / EBITDA keeps increasing while EBITDA / Interest keeps decreasing, the company may be relying on leverage to boost its ROE.
What does it say about a company if its Days Receivables Outstanding is ~5, but its Days Payable Outstanding is ~60?
It tells you that the company has quite a lot of market power to collect cash from customers quickly and to delay supplier payments for a long time. Examples might be companies like Amazon and Walmart that dominate their respective markets and that often make suppliers “offers they can’t refuse.”
What is the Cash Conversion Cycle (CCC), and what does it mean if, among a group of similar companies, one company’s CCC is 5, and another’s is 30?
The Cash Conversion Cycle is defined as Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payable Outstanding (DPO), and it tells you how much time it takes a company to convert its Inventory and other short-term Assets, such as Accounts Receivable, into Cash.
Lower is better for this metric because it means the company “converts” these items into cash flow more quickly, so a CCC is 5 is better than a CCC of 30.
This one also depends heavily on the industry: the CCC is often low (under 10) for large retailers, but it may be over 100 (or more!) in an industry like spirits, where Inventory may sit on the Balance Sheet for months, years, or decades.
