Working Capital Flashcards
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.
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.
