Working Capital and the Change in Working Capital in Valuation and Financial Modeling [REVISED]
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- čas přidán 14. 06. 2024
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Table of Contents:
0:00 Introduction
2:45 Part 1: Why We Care About the Change in Working Capital
4:33 Part 2: What is “Working Capital”?
9:56 Part 3: The Change in Working Capital
14:47 Part 4: Working Capital for Best Buy and Zendesk
18:23 Part 5: Is Item X a Part of Working Capital?
21:40 Part 6: Wait, Why Don’t the CFS and BS Figures Match?!!
26:01 Recap and Summary
Lesson Outline:
We care about the Change in Working Capital because a company’s implied value always depends on its future cash flows, and a big component of Cash Flow is the Change in Working Capital.
Therefore, the Change in Working Capital could positively or negatively affect a company’s valuation, depending on its business model and market.
Traditionally, Working Capital is defined as Current Assets minus Current Liabilities, but that’s not how companies calculate it in their financial statements.
A better definition is Current Operational Assets minus Current Operational Liabilities, so we exclude items like Cash, Debt, and Financial Investments.
The meaning of a positive or negative Working Capital depends on why it is positive or negative.
The Change in Working Capital, as shown on the Cash Flow Statement, equals Old Working Capital - New Working Capital.
It’s the opposite of what you normally do because Working Capital is a Net Asset on the Balance Sheet, and when an Asset increases, that reduces cash flow; when an Asset decreases, that increases cash flow.
For example, imagine that a company’s Working Capital consists of a single line item: Inventory.
If the company’s Inventory increases from $200 to $300, it must have spent $100 of its cash flow to buy that additional Inventory.
Therefore, the Change in Working Capital = $200 - $300 = ($100), so it’s negative and reduces the company’s cash flow.
When the company finally sells and delivers these products to customers, Inventory will go back to $200, and the Change in Working Capital will be $0 once again.
Cash flow will increase not because of Working Capital, but because the company earns profits on the sale of these products.
If the Change in WC is negative, the company must spend in advance of its revenue growth - like a retailer ordering Inventory before it can sell and deliver its products.
If the Change in WC is positive, the company generates extra cash as a result of its growth - like a subscription software company collecting cash for a year-long subscription on day 1.
The Change in Working Capital, therefore, depends heavily on the company’s business model, such as when it collects cash from customers, when it pays suppliers, and when it pays for Inventory relative to product/service delivery.
For Best Buy and Zendesk, we look at metrics such as the Change in WC as a % of Revenue and as a % of the Change in Revenue.
Since the Change in WC as a % of Revenue is quite low for both of them (low single-digit percentages), we know that Working Capital is not that significant for either company.
As expected, though, Zendesk’s Change in WC as a % of the Change in Revenue are much more positive, averaging around 10%, because it is a subscription software company.
We receive many questions about whether various items, such as Deferred Taxes, Income Taxes Payable, and Operating Lease Assets and Liabilities should be part of Working Capital.
The short answer is that you should follow what the company does, and don’t worry that much about placement as long as the item correctly factors into Cash Flow from Operations.
The only point to watch out for is that changes in Cash, Debt, and Investments, should NOT be anywhere in Cash Flow from Operations or the Change in Working Capital. So, if the company does this, remove these items and re-classify them.
Finally, the Change in WC as calculated manually on the Balance Sheet will rarely, if ever, match the figure reported by the company on its Cash Flow Statement.
This is normal due to different groupings of items on the statements, changed accounting policies, acquisitions, divestitures, and so on.
Don’t panic about these minor mismatches - just focus on the overall Change in Working Capital relative to Revenue and the Change in Revenue and make sure it makes sense going forward.
![US GAAP vs. IFRS in Valuation and Financial Modeling [REVISED]](http://i.ytimg.com/vi/jFplsqw3vG0/mqdefault.jpg)
You deserve 100k because this channel is amazing and is helping millions of passionate, motivated, underprivileged students.
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For many months, I've been looking for clarification of this concept of change in working capital. THANK YOU SIR!
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This was so useful and helped me enormously with a superday--cannot thank you enough, as someone coming from a liberal arts school, for providing such high quality material for free.
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i was so much confused untill i came across this video...cheers mate! u helped a lot here!
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For months I am looking for some material to clarify the working capital concept , Thank you ! Great Tutorial !
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I'm part of the silent majority, that ususally doesn't comment but man I really appreciate your guidance because I would have otherwise given up on DCF and gone back to Yolos and losing money. You're actually providing people with the opportunity for a better life. So thanks!
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Amazing content, I never learn that deeply in my past. Vary valuable content.
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Thank you very much for the content, it was really hard to find this information!
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Thank you for this brilliant tutorial.
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Well explanation. Thank you and appreciate that.
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excellent explanation. Awsome topic.
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Know you said not to drive myself crazy over this but it's exactly what im doing. Im trying to make a DCF model for evaluating companies and with how much of a impact the change in working capital has im going crazy to find the the right way. I was trying to see my numbers vs the website seekingalpha but those seem to make no sense so that drove me even crazier! Great video btw, taught me a lot.
Thanks. I'm not really sure how I can answer your question (or if you're asking a specific question).
Wow. Very good explained! Great!
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I watched this video 5 times at least!
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yes, this was a great session . thank you :)
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Well explained!
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Great content!
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I love this channel as someone who is interested in investing but did not study finance
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wow that titanic metaphor was very dark... hahaha. i honestly really enjoy your videos bc my company really doesn't follow the norms / same terms as most others. im exiting my current role for an FP&A one next month (at a new company) and am hopeful i can use your videos to sound half-educated! thank you!
Thanks. Yes, dark metaphors are our specialty here.
One in million video sir
Rich in content highly helpfulllll
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Congratulations!!!!!
Thanks!
thanks for the video and explanation. That really helps a lot. By the way, if someone jumps into a pit of lava filled with crocodiles, the crocodiles will already be toasted.
You're assuming the crocodiles do not have lava/flame-resistant coating...
GREAT VIDEO
Thanks for watching!
Thanks a lot for your content.. Could you probably upload a video on how an impact PE fund might approach financial modeling and how the underlying drivers could change?
Thanks, I'll see what we can do, but this topic is not terribly likely because impact investing is very specialized and there isn't much information on it.
Pit of lava filled with crocodiles?🐊 Some freaking crocodile that must be.
Thanks for such an informative session btw. :)
Thanks for watching! And yes, the crocodiles were highly lava-resistant.
Super helpful thank you very much !
I can relate to trying to match CFS and BS working cap 😂
Especially since I work in MM IB in Continental Europe a lot of private firms do not even disclose their CFS so you Need to deduct it from their BS and IS yourself 😂
Thanks, glad it helped!
Thank you for the informative video! I was just wondering the point you mentioned about how companies consider working capital items differently. In practice, does this mean that companies have different items included in their WC items for the calculation of NOPAT to FCFF? If so, do these discrepancies get adjusted when we're comparing between companies?
Yes, companies may include slightly different items in Working Capital, but it's often justified if their business models differ. You rarely make adjustments when comparing them unless it is something major, such as one company counting a huge Deferred Revenue balance in WC and another company with the same business model not counting it at all. This is rare since you're usually comparing companies in the same industry.
Dude, I love your videos. What do you think of Damodaran's approach where he usually doesn't use WC change to get to the free cash flow to the firm, instead he uses the reinvestment rate and subtract from NOPAT? It would be so sweet if you could make a video about it. But I'd be happy just to know your opinion about this.
We don't like that approach because it's disconnected from the company's real financial statements. Also, finding the true "reinvestment rate" can be tricky due to inconsistencies in historical WC and CapEx levels. It's a nice idea in theory/academia, but doesn't hold up that well in real life when you're given a set of financial statements and you have 30 minutes to value the company.
Thanks :D
Thanks for watching!
Thank you for all your videos. Really really appreciate it!
When calculating NWC from the CFO statement, why is it simply the sum off all the items? I thought its Current Operating Assets - Current Operating Liabilities, but when you calculating the Change from the CFO in other videos, I see you just added all the line items. In other words, in this case for Year 1 CHG NWC = [-348-156+1307+419] but I thought it would be calculated as CHG NWC=[-348-156]-[1307+419]
Because when companies list the Change in Working Capital on the CFS, it's already calculated as Current Operating Assets - Current Operating Liabilities or something similar. No further adjustments are required.
Congrats on 100k subs. Was just wondering can you write off accounts payable (don’t have to pay them back anymore). How would you reflect that in changes in wc, as it would not necessarily reduce CF? Would you just decrease expenses for the next period?
Thanks. An Accounts Payable write-off should not really show up within the Change in Working Capital section because it's a write-off, not the item going up or down naturally. It would be shown as a positive on the Income Statement (the opposite of an asset write-down), and it would be reversed on the CFS within CFO, so it would be a negative there. Expenses on the Income Statement in the next period should not decrease because AP correspond to expenses that have already been incurred but not paid in cash (at least in some cases... not true for something like Inventory being paid on credit).
@@financialmodeling That makes a lot of sense. Cheers!
How do you typically model credit card usage into WC? For example, we use CC for some inventory payments (balance sheet), advertising expense (income statement/gross expenses), and then general expenses
Credit cards are short-term/revolver debt, so they shouldn't really be a part of Working Capital in the first place. Nothing interest-bearing should go in there. Some companies will do this anyway and claim they're "not interest-bearing" since they are repaid each month, but if you look at the statements of large/public companies, no one lists Changes in Debt within the Change in Working Capital section.
If short-term Deferred Tax Assets are present on the balance sheet, should they be considered operating items and included in NWC or not? Thanks!
Deferred Tax Assets should not be a part of Working Capital regardless of their duration.
Thanks, Brian for the video. Just a quick query, Let's say WC turns from +50 in year 1 to -100 in year 2 (new). So this means a positive impact on Free cash right? We would "add" 150 as the "change in WC" and this shall boost my FCFF
Yes.
@@financialmodeling a negative working capital means CA 《 CL which means a current ratio 《 1. Accountants view this as a bad thing. However, the same situation is adding to my valuation as you replied above. How should we explain this trade off Brian. Its confusing to me
@@star5guy Working Capital by itself does not affect valuation, only the *Change* in Working Capital does. How accountants view it is irrelevant because valuation is based on cash flows, not accounting rules. The Change in WC translates a company's position into cash flows and makes it relevant for valuations.
Thanks for your video Sir. I have a question. Why the formula for Net change is : Account receivables + Inventories + Other Assets + Account Payables + Income taxes + other liabilities and not : (Account receivables + Inventories + Other Assets) - (Account Payables + Income taxes + Other liabilities) ?
??? What are you asking about? The formula for Working Capital is the one you suggested. You subtract Current/Operational Liabilities.
can i ask there could be a lot item in the balance sheet, is that u either treat it as operating or non operating, for the operating, it is included in the working capital and for other item they are included in the net debt when doing a valuation, so all item must be reflected either in the working capital or in the net debt?
This is true of many items on the Balance Sheet, but there are exceptions. For example, something like Net PP&E is clearly not in Working Capital, but it's also not part of the company's Net Debt. It's simply a long-term operational asset. The same applies to something like Goodwill.
So, I wouldn't necessarily recommend learning this as a "rule" - you can generally classify items as operational vs. non-operational, but just because something is "operational" doesn't mean it's part of the Working Capital.
Hey sir base on your explanation on change in WC (WC of last year - WC of current year), when doing FCF you are adding the change in WC right? I asked b/c from my professor we minus the change in WC when doing FCF, but the key difference is that we define change in WC as (WC current year- last year)
If Working Capital increases from one year to the next, it's a negative in the FCF formula. If it decreases, it's a positive.
I'm new to this channel. Also, I'm currently preparing for CFA Level-1.
Where do I begin to learn the concepts available on this channel?
Please guide!
I can't really answer your question because these are "quick tips" videos about different topics and are not arranged in a structured way. We give free samples and summary lessons in this video, not structured courses.
@@financialmodeling okay! Thanks, anyways. I'll start exploring then. Btw, keep up the great work.💯👏
Thanks for your video, it's great! However, I got lost. If I am calculating change in Acc. Payable for 2021 it is $100 and for 2020 it is $150. What number I will find in a cash flow statement: $50 or ($50)?
It should be ($50) because a Liability decreasing is a cash outflow. However, it probably won't match exactly because other items could affect this, companies group items differently, there may be acquisitions/divestitures/accounting rule changes, etc.
Should operating cash be part of NWC? In class, we used 5% of sales number as operating cash, and the rest i.e. excess cash as investment assets.
It's not a good idea to do that in financial statement analysis / modeling / valuation because the Net Change in Cash at the bottom of the CFS should track the total change in cash. You can run into issues with double-counting or forgetting part of the Cash balance if you split it up. Also, no companies show the change in operating cash in the Change in WC section of the CFS.
For some companies say for growth companies or companies early in their life cycle who have relatively less cash reserve than compared to the matured companies talking 5% the impact of doing that on cash flow during forecasting would be miniscule, and you can get away with that but think of doing that with company like Apple who has significant cash now apply the 5% rule the impact would be tremendous..
Also remember in finance there are lot of rules of thumb being concocted & one must always challenge them. I mean why 5% why not 2/3/8/12/14% who's making those rules?
The whole idea of considering operating working capital as oppose to accounting definition of working capital is that. By excluding cash from current assets & excluding short term loans from current liabilities. Say except for cash the amount invested in say inventory/accounts receivable does not earn any rate of return so they are wasting assets while cash earn a riskless return in bank. For short term loans/debt they add up to debt while calculating cost of debt during cost of capital computation.
For valuation purposes, is change in operating capital and change in NWC the same? Which is to say can I directly pull the value as change in NWC?
Yes, but be careful with how companies define "operating capital" because the definitions can be inconsistent. It's always best to use what's directly shown on the CFS.
hi M&A, I'm learning about how to calculate "Reinvestment" and materials out there say Change in Working Capital is part of Reinvestment, other than CAPEX. Is that true and justified? if what I want to calculate is how much the business reinvests into the business from their profit.
The reinvestment rate formula I found takes: Change in Working Capital + Net CAPEX (which is CAPEX - Depreciation) all over NOPAT. My other question is: why minus Depreciation? is it because NOPAT is accrual so we need to follow accrual accounting as well? Since I believe the "actual cash" outflow is still CAPEX.
So, can I calculate "reinvestment rate" by taking: (Change in working capital + CAPEX)/(NOPAT + D&A). Does that number mean what I want to find out? which is the actual cash reinvestment taken from cash profit?
I hope I am clear with my question and thank you so much for your educational content!
We don't set up models like that, but yes, you could view the Change in WC as "reinvestment." You subtract Depreciation because it's non-cash in the period, and CapEx - Depreciation over the long term tells you how much the company needs to spend to maintain/grow itself. Can't really comment on the reinvestment rate because we never use that approach, as it's easier from a modeling perspective to work off the company's financial statements as is.
1. hi what if company does sort term cash borrowings lets say in year 1 no short term cash borrowings but in year 2 short term cash borrowing is 100 in cash ( current liabilities ) so change in working capital will be Assets (0) - Cash Liabilities (100) = -100 but cash has come inside business ? i have seen companies using this to inflate their cash balances even for long term debt. How will this go in cash flow statement ? as cash has come in but in cash flow as per formula will be -ve ?
2. in berkshire cash flow they are showing Investment (gains) losses -77B (negative ) etc year 2021 in operating activity what does that mean they bought investments or they had loss on investments ? they need to more clear what is going on, loss should be mentioned as loss and purchase should be mentioned as purchases. pls have look ty
Cash and borrowings should never part of "Working Capital," so I don't understand your first question. If a company is doing this, you should adjust by removing them. Your second question has nothing to do with this topic so I will not answer it in detail, but companies now record both realized and unrealized gains on equity investments (small stakes in other companies) on the IS and reverse unrealized gains/losses as non-cash items on the CFS.
I could be wrong but on BS, the current assets and liab is defined by time horizon (under 1 year) whereas on CF it's as you said classified by the company based on their interpretation of operating assets and liab
Yes, that is correct, but the issue is that companies do not spell out exactly which portions of which assets and liabilities are considered "operational," so there is always guesswork involved.
Should i include VAT while calculating change in WC
Follow whatever the company does on its financial statements.
AT 9:50, you say that the company is not collecting cash upfront, if that would have been the case wouldn't AR balance (presumed to be part of other current assets), further negatively impacting the WC? Also this is a retail business, which will have limited/nil customer receivables, so what are you implying to when you make reference to limited cash collection upfront?
Any time a company *delivers* a product or service without the customer paying in cash at the same time as the delivery, the AR balance increases. So I am not sure what you are asking. Working Capital itself increases when this happens because Working Capital = Current/Operational Assets - Current/Operational Liabilities, so an increase in AR increases Working Capital. It's just that the *change* in AR as defined on the Cash Flow Statement becomes more negative.
Plenty of retail businesses can have receivables. Even offline/physical stores might allow for phone/internet/other remote orders where the payment is not immediate/upfront. Look at any retailer's Balance Sheet, and you'll almost always see a line item for Accounts Receivable. Yes, AR will be lower than it would be for other types of businesses, but it's still there.
In the example @ 9:31, Comany B may be in better position as they are using their suppliers to fund their Working capital requirement, indicating it’s market strength
Maybe, but without additional information, we can't really say for sure.
Does "Other Current Assets" include Account Receivables (Debtors) ?
If AR is not shown as a separate line item, yes, it's often included in Other Current Assets.
@@financialmodeling Thanks a lot! On a side note, you are doing a great job and your channel is very informative and helpful. Thanks a ton :)
Super
Thanks for watching!
Thanks, I was driving myself crazy by comparing the net working capital change (from balance sheet) and the NWC change in the ADBE's cash flow statement (and with other stocks too). For example, receivables doesn't match. So, it might be normal then.
Yup, it will never match exactly. Just accept it and move on.
can you do a change in working capital of mmm of 2007?
Im reading The Little Book of Valuation and I tried your method but somehow I didnt get Damodarans answer of 243 million
Ive been stuck on this literally for days. Thanks so much
Sorry, we can't comment on other books/resources/assignments in this channel, only on the material presented in these free tutorials. I wouldn't worry if your answer is reasonably close.
If "Accounts Receivable" is included in "Current Assets", then the change in WC (Old WC - New WC) explanation makes a bit less sense to me. I understand that you need to pay for the additional $100 in inventory, but how does that apply to AR (if AR went up from $200 to $300)?
In that case, isn't the only outflowing cash the COGS associated with delivering that additional $100 of services that you haven't yet been paid for?
If AR increases from $200 to $300, it means the company recorded more revenue but did not collect it in cash. Therefore, its cash flow needs to be reduced because revenue alone is overstating how much in cash receipts the company gets. If there are COGS associated with this additional revenue, the cash flow impact depends on whether the COGS are paid for upfront in cash upon product delivery or if they're deferred and paid in cash later (i.e., part of accounts payable or accrued expenses).
Accounts Receivables means customer has not paid the sales price for the goods that it bought. But sales price =value of goods + sales tax. Will AR include sales price or sales price minus sales tax.
Depends on how the company's statements are set up, but if "Revenue" also includes sales tax, then AR should also include sales tax because the customers are responsible for paying sales tax to the company, so it counts as a receivable as well... it is completely pass-through on the statements, though, because it's recorded as revenue and then just paid out as an expense to the government.
@@financialmodeling so in income statement the tax rate that is used to calculate PAT will also reflect indirect taxes along with corporate tax ??
@@rachitsingh9473 No, just corporate taxes.
21:17 Can someone tell me which IFRS he is reffering to?
"IFRS" refers to the international accounting standards for financial reporting. Companies outside the U.S. use IFRS, or a local variation, to report their financial results. www.ifrs.org/supporting-implementation/supporting-materials-by-ifrs-standards/
hello! is the excel spreadsheet avail for download?
Click "Show More" and click the links.
I ve recently discocerd this channel. You are great. Thanks
Thanks for watching!
Hey. So if the Inventory was 400 in year 1 and then 300 in year 2. Youd be adding 100 to cash flow, but isn't that telling us that the company sold last years left over inventory so it's being extra cash from selling extra inventory. And if its receivables. Year 1 400, year 2 300. Wouldn't that imply that the company collected all if its year 2 receivables plus got extra cash this year from last years unpaid receivables that it carried over into year 2?
Yes, but in both those examples, the company has likely cycled through its AR and Inventory several times over the course of the year. They tend to be short-term and rarely last more than a few months. But if Inventory decreases and AR decreases from one year to the next, the company's cash flow should be more positive as a result (as assets decreasing always boosts cash flow).
@@financialmodeling
By cycle you mean how long it takes the comp to cash them? What I'm trying to ask is can these curent assets be held into the following year and then is yes then it makes sense why there is being extra money being added. So if a comp has a balance sheet ending Dec/25th/2022 with AR being 300 and then Dec/25/2021 ending balance sheet with 400 in AR I'd add 100 to my NI in 2022.
NI for 2022 $300
AR. $100
Cash from operations $400.
@@augustusg857 Yes, that can happen. My point above is that AR rarely remains outstanding for an entire year, so if you want a more realistic time frame for these numbers, you should look at monthly or quarterly financial statements. In those cases, if AR increases from 300 to 400 over the span of a month because nothing has been collected but there has been one new purchase for 100 (also not collected), then the company's revenue will increase by 100 and net income will also increase as a result (less than 100 due to taxes and other expenses).
@@financialmodeling
And that 100 increase in AR is a 100 decrease In cash flow since it's in credit. Ok I get it. I really do appreciate you taking time to respond.
Is the earlier video taken down?
Yes
@@financialmodeling Thanks for confirming mate. Cheers and happy new year!
Some inspirational quotes from this video: “On the titanic that doesn’t matter because most people are still going to die” and “if you try to do this you will jump off a building”
Side note love the videos.
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