Working Capital, Free Cash Flow, and Other Metrics and Ratios

Question 1

What is free cash flow, and what does it mean if it’s positive and increasing?

Answer 1

Cash flow from operations minus CapEx

FCF represents a company’s discretionary cash flow - how much it has left for other areas after spending what’s required for its business.

If it is positive and increasing, it means the company can spend its excess cash in different ways: it could hire more employees, spend more on working capital or CapEx, invest in other assets, repay debt, acquire other companies, or return money to shareholders with dividends or stock repurchases.

Question 2

What is working capital?

Answer 2

Current assets minus current liabilities

or

Working capital = Current Assets (Excluding Cash and Investments) - Current Liabilities (Excluding Debt)

Working Capital by itself tells you whether a company needs more in operational assets or operational liabilities to run a business, and how big the deference is. But the change in working capital matters far more for valuation purposes.

Question 3

What does the Change in Working Capital mean?

Answer 3

Tells you if the company needs to spend in ADVANCE of its growth, or if it generates more money as a RESULT of its growth.

Changes in Working Capital directly increases or decreases Free Cash Flow, which, in turn, directly affects the company’s valuation.

Question 4

A company’s current ratio is 2x. Why is that NOT necessarily a positive sign?

Answer 4

The current ratio is defined as Current Assets / Current Liabilities, so it depends on what’s in both those groups.

Question 5

Would you expect a retailer or an airline company to have a higher asset turnover ratio?

Answer 5

Generally, the retailer will have a high asset turnover ratio (Revenue / average assets) because it is less dependent on assets to generate its sales. Yes, retailers need to sell inventory to make money, but they don’t necessarily need to own their own stores

An airline will tend to have a lower asset turnover ratio because it is completely dependent on PP&E to generate revenue: without its planes, it can’t do much of anything.