DCF Net working capital question
I've been working on a model for a newer, very high-growth company that sells protective coverings for electronics. Basically, when calculating free cash flow to the firm, if I change my assumption regarding an increase in NWC by only 1%, my FCFF decreases by almost $1 mm (about a 25% decrease for this company).
Is it normal for this to happen for newer very high-growth companies? Should net working capital growth be pretty much in line with sales growth, and should it have such a major impact on FCFF in this company's case?
Thanks for any help/advice you can offer.





First off what are you
First off what are you driving your NWC off of? I don't have a ton of experience modeling small companies but I've always driven it off days payable and days receivable. If they're generating rev's or shipping product this should be your growth metric. Unless you've been told to drive WC as % of sales this is how you should do it.
Also, when margins are slim your bottom line is extremely sensitive to expenditures i.e restaurants; that could be another reason.
I normally drive it off of
I normally drive it off of DSO / DPO, but this is for a class and the professor has given us a very specific template... we're not even supposed to drive the NWC off of sales, we are cutting right to the chase and driving the change in NWC off of sales.
So for example, my historical period is 2007-2009 and the Changes in NWC as a % of sales are 13.6 and 18.8% respectively. In my projection period, I flatlined the change in NWC as a % of sales at 20%.
I know that in a more detailed model you would build out the balance sheet and make assumptions regarding accounts payable / receivable with regards to sales, but in this simple example, I'm not sure if I'm going about projecting the NWC the right way... I've never done it like this.
Your model isn't wrong, what
Your model isn't wrong, what it's doing is exposing an unpleasant reality about growing companies. The projections and prospects for a company can be as rosy as you want, but if the company does not know how to manage cash, things will go very very wrong for them very quickly. This is just people operating efficiently and in the real world this is very very hard to do. For most companies that fail, poopr cash management is the reason they fail. Get it wrong just a little bit, and a good business model goes to shit overnight.
I've never seen / heard of
I've never seen / heard of driving CHANGES in NWC off of sales. With limited info, most comprehensive way to drive NWC is assuming constant A/R days, Inv, days, A/P days, etc from last actual year of financials. After that, I see NWC driven as a % of sales. Driving changes in NWC off of sales vs. NWC off of sales may be why FCF is so sensitive here.
Thanks for the responses
Thanks for the responses guys:
Acronymous, I agree with you which is why I don't get why this template tells us to drive changes in NWC off of sales growth. I think I will just build out the balance sheet and see what I come up with.
It is best to forecast
It is best to forecast working capital components in the Balance Sheet first followed by calculating 'deltas' in the cash flow. NWC should never be linked to Sales or any other 'single' item.
However, being a high growth company, the asset investments may be huge, causing the EBIT margins to be poor as a result of high depreciation (the main driver for the FCF calculation!) this may cause WC to act as "operating leverage" in the case.
Are they mainly doing on-line sellers? If yes, it is highly unlikely that they will have a positive working capital in the first place!
--
The Finatics Blog
It is best to forecast
It is best to forecast working capital components in the Balance Sheet first followed by calculating 'deltas' in the cash flow. NWC should never be linked to Sales or any other 'single' item.
However, being a high growth company, the asset investments may be huge, causing the EBIT margins to be poor as a result of high depreciation (the main driver for the FCF calculation!) this may cause WC to act as "operating leverage" in the case.
Are they mainly doing on-line sellers? If yes, it is highly unlikely that they will have a positive working capital in the first place!
--
The Finatics Blog