4/23/11

To any/all who can advise on a question I have regarding the following, I'd have much gratitude:

I am working out a Valuation model for a theoretical Steel MFG outfit, using a Free Cash Flow - NPV approach to find a value for the firm. I have mocked up financials, and only a small amount of information in the instructions to go off of.

My main issue: after applying the FCFF approach for Free Cash Flow (FCF = EBIT (1-tax) + Depreciation - Inv. in CapEx - Inv. in NWC), I am not sure about 2 things:

1. NWC: Net Working Capital: I understand this to be the change in Current Assets - Current Liabilities, however, I seem to get a different interpretation of 'Current Assets' depending on where you study it. Shall I include 'Cash' as a portion of Current Assets, considering the business in question is a Steel manufacturer?

2. Discount Rate: This firm is raising capital, and a VC is evaluating them, and the VC requires a 30% return... Can this be applied as the 'Discount Rate' in the model?

Thanks so Much to all.
I look forward to finally getting some clarification on this.

C.G. Hensel II

Comments (104)

4/23/11

1. Cash - do not include cash.
2. They want a 30% equity IRR (not 30% IRR on the project). Use this as the cost of equity if you have to in discounting the FCFF (and of course when arriving at the discount rate = WACC you would need to include the cost of debt and the target leverage assumptions)

Not all shareholders will want this high a return I guess. So, an alternative approach could be to use the FCFE, and use some exit assumption for this company (probably you meant PE and not VC as this is a steel mfg co, and they would have some exit horizon like 3-7 years in mind)

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4/23/11

Thank you Much,
1. Cash: I will omit cash as a portion the current assets, with respect to the change to Net Working Capital, thank you.
2. The 30%... Yes, I interpret the 30% as a required return on the equity the VC is providing the manufacturer... I was just thinking that, without any indication or direction on the Cost of Debt or Cost of Equity, in lieu of anything specific, I could simply apply the return the VC requires as the 'hurdle rate' (discount rate), in order to see how the value looks...

Im trying to estimate a value via 1. NPV approach, and 2. VC method... I am given an industry P/E of 12x, and I am going to use that multiple in finding Terminal Value in the DCF (NPV), and I will also use that as an exit value in the VC method... The time horizon is 5 years.
Given this, does anything change within your reply? Thanks for the guidance. Very Much appreciated.

vaguefunda:

1. Cash - do not include cash.
2. They want a 30% equity IRR (not 30% IRR on the project). Use this as the cost of equity if you have to in discounting the FCFF (and of course when arriving at the discount rate = WACC you would need to include the cost of debt and the target leverage assumptions)

Not all shareholders will want this high a return I guess. So, an alternative approach could be to use the FCFE, and use some exit assumption for this company (probably you meant PE and not VC as this is a steel mfg co, and they would have some exit horizon like 3-7 years in mind)

4/23/11

Oh, one other question: can changes in NWC produce a negative value? What is the implication there? Once 'Cash' is removed, so current assets )A/R + Inventory) - current liabilities (A/P) = Current Liabilities > Current Assets, thus yielding a negative value...? But what is that telling me?

vaguefunda:

1. Cash - do not include cash.
2. They want a 30% equity IRR (not 30% IRR on the project). Use this as the cost of equity if you have to in discounting the FCFF (and of course when arriving at the discount rate = WACC you would need to include the cost of debt and the target leverage assumptions)

Not all shareholders will want this high a return I guess. So, an alternative approach could be to use the FCFE, and use some exit assumption for this company (probably you meant PE and not VC as this is a steel mfg co, and they would have some exit horizon like 3-7 years in mind)

4/23/11

Doesn't matter that NWC is negative for one year - all it means from a practical perspective is that you have to finance this with either borrowing - or the cash you now have free on your balance sheet.

P.S. what you should be using in your model is not NWC, but changes in NWC. So if NWC is -100 one year and -90 another, the change is + 10, which means you get -10 added to cash (increases in NWC decrease cash)

4/23/11

Yes, I am using the change between periods of NWC, I am not using the NWC value itself.. I wasn't clear with what I meant, I calculate the Net Working Capital requirement for that period, and then for the FCFF calculation, I use the difference... thanks for clarifying, but that was one thing I had going for me in this!

I think I got it all to work out, thank you very much for your help, I have been muddied down for two nights trying to work through different scenarios, values, calculations, reading differing perspectives on WC... I really appreciate the help.
Thanks again.
CGHII

dazedmonk:

Doesn't matter that NWC is negative for one year - all it means from a practical perspective is that you have to finance this with either borrowing - or the cash you now have free on your balance sheet.

P.S. what you should be using in your model is not NWC, but changes in NWC. So if NWC is -100 one year and -90 another, the change is + 10, which means you get -10 added to cash (increases in NWC decrease cash)

4/23/11

Your NWC question is already answered

You cannot use the 30% to value the whole firm - the rate will be too high to give any meaningful value. You presumably have the interest rate of debt (after all you will need that to get the earnings no. as well to apply the P/E ratio)? In the absence of anything else, you can use that as a cost of debt.
Alternatively, from the FCF no. that you get, subtract the interest payments and principal repayments (if any). You get the free cash flow to equity. Discount this with the 30% to get the equity value and add back the net debt to get the enterprise value

4/23/11

Vague,
Well, no, I don't have those figures, I basically was told that a VC wants to invest $18MM in a steel mfg company, there are 10,000,000 shares out, steel companies in the industry are selling for P/E of 12... Then I get a Balance Sheet, and an Income statement (only 'total revenues' less about 6 line items equaling 'total expenses' (rent, cogs, advert, salaries, misc, & deprec... ), after which is Profit/Loss.
A bit more detail is given:
estimate firm value using a 30% tax rate, using the NPV approach and the VC method to estimate the % of equity this VC will require to make the investment - assume the steel company goes public 5 years after the investment, which is made at the end of year 0. The lead Manager representing the VC assumes two follow-on equity offerings of 20% and 10% will be needed. The VC requires a minimum of 30% ROI. Calculate % ownership at IPO, retention ratio, price per share, # of shares and % ownership required at the time of investment.

So, am I completely missing something that's glaringly obvious, that is to say, in my approach, and furthermore, can I deduce those variables that you were mentioning from any of this info?? I didn't think I could, so I used the "Profit/Loss" as an EBIT value, and went from there into the FCF model...

Where am I going wrong???!!!

vaguefunda:

Your NWC question is already answered

You cannot use the 30% to value the whole firm - the rate will be too high to give any meaningful value. You presumably have the interest rate of debt (after all you will need that to get the earnings no. as well to apply the P/E ratio)? In the absence of anything else, you can use that as a cost of debt.
Alternatively, from the FCF no. that you get, subtract the interest payments and principal repayments (if any). You get the free cash flow to equity. Discount this with the 30% to get the equity value and add back the net debt to get the enterprise value

4/23/11

So, I figured out the NWC, removed that from the( EBIT (1-tax)+ Depreciation), then less the CapEx investment for the period, and I have a way better looking set of FCF's... Negative FCF the first year, and subsequently increasing every year after (with the exception of year 3 w/ a significant investment in PP&E)... I come to year 4, final year of projections, and use the P/E multiple to estimate the ongoing value of the subsequent CF's after Yr4, and add that to the FCF from YR 4... PV all FCF's, along with the terminal value, all at 30% discount rate (reflective of the VC's 30% ROI requirement) and that's giving me a decent looking valuation model and output...

I am a rookie at this, so please tell me if I am being ridiculous with any of the above!! I wanna figure this out!

vaguefunda:

Your NWC question is already answered

You cannot use the 30% to value the whole firm - the rate will be too high to give any meaningful value. You presumably have the interest rate of debt (after all you will need that to get the earnings no. as well to apply the P/E ratio)? In the absence of anything else, you can use that as a cost of debt.
Alternatively, from the FCF no. that you get, subtract the interest payments and principal repayments (if any). You get the free cash flow to equity. Discount this with the 30% to get the equity value and add back the net debt to get the enterprise value

4/23/11

Any unrestricted cash (i.e., cash not needed to fulfill a minimum balance requirement) should be excluded from current assets when calculating working capital.

4/23/11

okay that makes sense now that you mention that... this would mean that the formula should basically be FCF = accounts/notes/etc receivable + inventory + supplies - accounts payable... correct?

4/23/11

I assume you mean working capital, not FCF, correct?

You have most of the working capital categories covered, although 'supplies' would generally be more broadly included in a current asset account such as Prepaid Expenses / Other Current Assets. On the current liabilities side, in addition to Accounts Payable you'll often also have Accrued Liabilities and Taxes Payable / Other Current Liabilities as categories.

4/23/11

gotcha, and i guess the logic behind this is if your liabilities are increasing (such as accounts payable), you're not actually spending that cash, so you have more FCF... and an increase in inventories, accounts receivable, etc would translate to using up cash to purchase said items, thus decreasing your FCF... does that sound about right?

and for forecasting FCF, whats a good method for predicting future capex? would you just assume that capex growth is equivalent to revenue growth projections (at least for the purpose of answering in an interview, im sure its more complicated than this in real life, but would using revenue growth figures be an appropriate answer)?

4/23/11

For an interview, assuming capex growth consistent with revenue projections seems entirely reasonable.

Of course, it may be worth asking the interviewer about the historical relationship between revenue and capital expenditures (e.g., some businesses become increasingly more capital intensive as they grow, while others become increasingly less so).

4/23/11

thanks smuguy, i apprecaite the help

4/23/11

Required cash

  • ........
  •  4/23/11

.

4/23/11

WC = Current Asset - Current Lib

Lots of ways to interpret that I guess...

4/23/11

(vs. an accounting). Cash/near cash earns a fair return, and think about where that change in NWC is going: into your cash flow calculation, which is being discounted by the opportunity cost of capital. Wouldn't make sense to discount it.

4/23/11

Include required cash.

Include Any CAPITAL that is required for (current working) operations.

Exclude any items that are excess, non-cash, or non-current. For liabilities, generally exclude current portion of LTD

From an M&A standpoint
PM me for ques

4/23/11

the revolver is usually the plug here, not cash

4/23/11

Okay - just checking. While I was analyst, I was taught to always exclude cash (although included minimum cash requirements sometimes) and exclude current debt.

However, I have seen people include ALL cash in their NWC calculations for DCFs, and this has never made sense to me.

4/23/11

Good post but I don't think the example in the parent is right. The cash outflow going to inventory should be more than offset by the cash inflow from AR (usually or otherwise you're losing money).

So the example would be more like:

Ex.
Year 1 Year 2
Cash 100 50
AR 50 100
Inv 50 75

AP 100 100

WC w/ cash 100 125
WC w/o cash 0 75

Like the post says, I guess you would only count the part of cash in WC.

Maybe the original example could refer to a growing company increasing its inventory, but in that case I would think a growing amount of cash would be included in WC.

4/23/11

If the change is positive you subtract.
If the change is negative you add.

4/23/11

working capital is made up of:

current assets - current liabilities

The current assets portion usually includes: A/R, Inventory
So as you can imagine as any of these goes up, your working capital will go up, but you are not generating any free cash flows. So you are counting these as revenue, but you haven't received the cash (or in the case of inventory you have paid for inventory but it isn't part of COGS because you haven't sold it).

The current liabilities portion is just as it sounds, you can think of it as A/P (any short term liabilities)
As this decreases you are paying off liabilities, therefore your WC goes up, but, again your CF go down (you are using cash to pay debt).

I think this should be enough info, although quite simple...maybe someone better versed in this topic will chime in

4/23/11

One reason: accrual method of accounting

4/23/11

What about it Sof? It would be good if you can explain coherently please.

4/23/11

Let's imagine you're running a lemonade stand:

You sell 100 drinks at $2.5 each: Revenue $250
Each drink costs you $1 to make: COGS $100
Permit cost and colorful sign on the corner: $25
Depreciate your lemonade stand: $25
Operating income: $100
Pay taxes at 35%: $35
Operating income net taxes: $65
Add back depreciation: $25
Cash flow before capital needs: $90

I assume you're still with me at this point. You made some money, had some expenses, paid taxes on your income and added back non-cash expenses. This is the cash your business has generated before we consider any capital expense.

Assume you pay all your bills in cash and don't have any payments outstanding. Assume also that everyone pays for their drink when they drink it. Thus AR and AP are zero, but more importantly, they are equal so they cancel each other out.

Let's say you expect business to kick up over the next year. You need to buy an new ice cooler (capital expense) to stock more ice. This costs $15. You used to keep 100 cups on your stand before running across the street to get more. You don't think you'll have time to run around buying cups for all the new customers. So you plan on keeping 200 cups at the stand. You're increasing your inventory by 100 cups. 100 cups costs $25. Where did you get the cash for these $40 in PPE and inventory? From your business! You have to subtract your investments from your cash flow. You made money, and you spent money. What did you spend it on? You spent it on cups and a cooler.

So your FCF is $90 - $40 = $50

Working capital is an investment like anything else. It requires cash.

4/23/11

jhoratio:

Let's imagine you're running a lemonade stand:

You sell 100 drinks at $2.5 each: Revenue $250

Each drink costs you $1 to make: COGS $100

Permit cost and colorful sign on the corner: $25

Depreciate your lemonade stand: $25

Operating income: $100

Pay taxes at 35%: $35

Operating income net taxes: $65

Add back depreciation: $25

Cash flow before capital needs: $90

I assume you're still with me at this point. You made some money, had some expenses, paid taxes on your income and added back non-cash expenses. This is the cash your business has generated before we consider any capital expense.

Assume you pay all your bills in cash and don't have any payments outstanding. Assume also that everyone pays for their drink when they drink it. Thus AR and AP are zero, but more importantly, they are equal so they cancel each other out.

Let's say you expect business to kick up over the next year. You need to buy an new ice cooler (capital expense) to stock more ice. This costs $15. You used to keep 100 cups on your stand before running across the street to get more. You don't think you'll have time to run around buying cups for all the new customers. So you plan on keeping 200 cups at the stand. You're increasing your inventory by 100 cups. 100 cups costs $25. Where did you get the cash for these $40 in PPE and inventory? From your business! You have to subtract your investments from your cash flow. You made money, and you spent money. What did you spend it on? You spent it on cups and a cooler.

So your FCF is $90 - $40 = $50

Working capital is an investment like anything else. It requires cash.

this is a really great example.

4/23/11

Do you subtract working capital in FCFF and FCFE, or just FCFE?

4/23/11

jhoratio thats a good example... but you would't subtract the cost of the cups/inventory from CFO... just the ice cooler. The change in, and cost of cups (inventory) are already baked into your delta in W/C.

So [CFO - CapEx] would be $90-$15 = $75 FCF

edit: econ you have to subtract/add the change in W/C to get to CFO, which you need to get to all other FCF measures.

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4/23/11
AssociateGuerilla:

jhoratio thats a good example... but you would't subtract the cost of the cups/inventory from CFO... just the ice cooler. The change in, and cost of cups (inventory) are already baked into your delta in W/C.

So [CFO - CapEx] would be $90-$15 = $75 FCF

edit: econ you have to subtract/add the change in W/C to get to CFO, which you need to get to all other FCF measures.

I see what you're saying, but where did I already bake them in? Since AP and AR are both 0 and not expected to change, the only change is increase in inventory, which I hadn't subtracted yet. You still need to take away that cash.

4/23/11

Without the accrual method of accounting (i.e., you only record cash transactions), there would be no need to subtract the increase in the change of NWC in your FCF projections. The ONLY exception to this would be an increase in the inventory account, which reflects a cash outlay in inventory. All the other WC accounts are a result of the accrual method of accounting.

There is not much more to it.

4/23/11

Sorry, but what do you mean by CFO? (I tried googling it, but just got Chief Financial Officer.)

Also, what are good resources for learning this stuff?

4/23/11

CFO = cash flow from operations

good resources? any good finance book or the internet

4/23/11

jhoratio, great example. Its nice when things are broken down in an easy to understand scenario.

4/23/11

Jhoratio the change in cash flows thru to COGS which in turn flows to net income, which is your starting point for CFO calculation in the indirect method

flow baby, flow!

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4/23/11

It's probably better to understand this intuitively.

Cash Flow from Operations (before Working Capital) represents the income statement without any non-cash charges (D+A, etc). That said, suppliers still need to get paid, some customers buy on credit, etc. An increase on the liability side increases cash on hand - an increase on the asset side as the opposite effect.

All in all, you need cash to operate the business. If you don't factor this into FCF, then it isn't "free".

4/23/11

mlamb please don't confuse the poor guy, Cash Flow from Ops definitely includes your changes in working capital...

Start with Net Income
+ Depreciation Expense
+ Amortization Expense
+/- increase/decrease in Deferred Tax Liabilities or Assets
-------------------------------------------------------------------------------
= FLOW OF FUNDS

- (postive changes in current assets) <- think, if you add to A/R, that's something you booked as sales and hence included in net income, but was NOT a cash flow

+ (negative changes in current assets) <- same reasoning. If you collect an A/R, you did not book it as sales but you did collect cash. Hence it was a cash flow

+ (positive changes in current liabilities) <- inverse reasoning from above, think A/P and COGS
- (negative changes in current liabilities)
= CASH FLOW FROM OPS

Step 1: Dream the Dream || Step 2: Live the Dream || Step 3: Rinse, repeat.

4/23/11

I never said it didn't - I was referencing CFO before WC changes. This is a common metric for companies that have volatile WC (e.g. energy companies due to commodity prices, companies with seasonal sales trends).

He was asking for the reasoning behind subtracting WC when computing CFO. I was explaining it to him without just running through the calculation.

4/23/11

Reviving this thread. when you said positive changes in current assets how does that apply to inventory. doesn't inventory apply to cogs so when inventory goes up. why do you subtract it if its booked as COGS shouldn't you add back change in nventory?

4/23/11

azndarkvader:

Reviving this thread. when you said positive changes in current assets how does that apply to inventory. doesn't inventory apply to cogs so when inventory goes up. why do you subtract it if its booked as COGS shouldn't you add back change in nventory?

Typically inventory buildup/drawdown isn't booked in COGS if they're not being recognized as sales, so the cash being used isn't accounted for in the income statement. That's why you account for it in the change in working capital. Example: a store doesn't book all the merchandise it stocks its shelves with as COGS right when they buy it, only when they sell it (or write it down). But it's still a cash drain on the business in the period they stock the shelves.

I hate victims who respect their executioners

4/23/11

Got it. My thoughts exactly because the inventory buildup wasn't accounted for in the income statement. I've just read on different threads that it referred to COGS but it shouldn't since its not on COGS until its sold.

And the change in inventory is created by an exchange of cash not COGS.

4/23/11

ok CFO before delta in W/C is called flow of funds. Just terminology - nevermind.

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  • Anonymous Monkey
  •  4/23/11

Back to Jhoratio's example, I would expect that inventory is not included because inventory and cash are both a part of current assets, so the increase in inventory when it is purchased would not affect current assets, since inventory increases by the same amount cash decreases. This would not be the case with the ice cooler, which is a part of PP&E.

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4/23/11

working capital is capital the firm has to "work" with ... in other words, its not just paper capital ... think CA- CL

4/23/11

What?

It's Current Assets - Current Liabilities.
'Current' means lasting for a year or less, or the 'operating cycle', whichever is longer.

examples of CA: cash (less restrictions), receivables (less allowance for doubtful accounts), inventories, prepaid expenses, supplies
examples of CL: payables, unearned revenue, bonds payable (within a year), interest on bonds payable

The 'operating cycle' is the time between when supplies for making the product are received and when cash for the sale of the product is received.

4/23/11

Working capital from a practical standpoint just means stuff that the company needs to buy in order to have a "buffer" during operations. For example if you were operating Apple you would need to sink cash into producing IPhones as an inventory to ensure you don't have stockouts.

Because a company doesn't just buy the initial inventory - they maintain that level for some period of time, working capital is like an investment in time zero, which you can 'sell' at the end of the project life when you don't need the inventory anymore.

Similar premise occurs with other elements of working capital like AR/AP - you don't immediately get paid and don't immediately pay your vendors, so as production and sales ramp up you have a buffer of unpaid and uncollected invoices.

4/23/11

anyone else?

4/23/11

This is incredibly lazy. What do you plan to do when you start working and actually have to use your brain?

4/23/11

You want to be an I-Banker?!?! go to a pizzeria and ask the owner and then multiply his explanation by a couple of billion dollars. You will get a grasp of what working capital is in a big company.

"The higher up the mountain, the more treacherous the path"
-Frank Underwood

4/23/11

When I will start working I will ask the people that I am working with what the fuck WC is. Till then, I'm gonna use this forum for advice. I've already done research about this and got a multitude of confusing/different answers.

4/23/11
wamartinu:

When I will start working I will ask the people that I am working with what the fuck WC is. Till then, I'm gonna use this forum for advice. I've already done research about this and got a multitude of confusing/different answers.

Why are you going to throw a fit because you don't understand the simple concept of working capital?

In all these websites, did you read: http://en.wikipedia.org/wiki/Working_capital

That is more information than anyone at work is ever going to give you.

4/23/11

Read a fucking book. Or learn how to use google, or maybe both would do you some good.

Gang, Gang, Gang

Best Response
4/23/11

warmartinu,

I will answer your question, but know this: just because you "googled it" or "read tens of websites" [sic], doesn't mean you have exhausted your research options. Go to the goddam library and read a fucking book - hopefully one that's more than a paragraph in length. You "read...websites." Congratufuckinglations.

Now, to perpetuate and reward your laziness:

Imagine, as I often ask people to do, that you desire to enter the hypercompetitive soft-drink market by opening up a lemonade stand. What will you need to do this? Do you just stand there like a nincompoop reading tens of websites about it? How will you get lemonade? How will people know you're in business?

First you need a stand. Then some land to put it on. Then a sign so people know where you are. Then a cooler for ice and shelves for other items. These pieces of equipment represent your invested capital. They show up as Property, Plant and Equipment on the balance sheet. To the extent you buy them with your own money or with borrowed money, the claims on those assets are shown as equity or debt. Still with me?

OK, let's serve some lemonade. Wait - we have no fucking lemonade to serve! This is a problem indeed! Now, will the fucking lemonade fairy come down from the sky with fresh cups of lemonade for you sell or do you think you'll have to go shopping again? ....I'll wait for you...no, I'm afraid that's not correct, you will in fact have to make some additional purchases if you plan on making any money. No one is going to pay you just so you can smile at them standing in front of your sign.

You will need to buy cups, water, lemons, sugar, ice. Everything that goes into creating a serving of lemonade. David Ricardo (he is a famous economist who wrote very good books on the subject) talks about the relative "speed" with which capital investments are exhausted, and from here was born the concept of working capital. Basically, working capital is the amount of money you need to operate the business after the investments in fixed assets have been made.

So you go and buy $100 worth of materials. The store gives you a bill and tells you to pay in 30 days. On the 10th day, there's a run on your stand and you use up all the materials selling lemonade making $150. Each time you made a sale, you gave the customer a bill and told them to pay in 30 days. 20 days pass and your bill is due at the supply shop. Hmm, what to do? You sold all your supplies but still haven't gotten any money from your customers. You need to pay the store $100.

Now this may be a cause some unpleasant tingling in your forehead, but let's think about this for a second. The day before the bill was due, your AR was $150, your Inventory was $0 and your AP was $100. So, technically, your net working capital (NWC) was $50. The day after you paid your bill, (AR = $150, Inv. = $0, AP = $0) so NWC was $150. Hey, it went up! What does that mean!? These fluctuations in and of themselves are not very important. The thing to understand is this: if all goes smoothly, there are exactly 10 days that you have to come up with financing for $100 - this is the span of time between when you owe the store and when you get paid by your customers. THIS $100 FOR 10 DAYS IS WHAT YOU NEED TO OPERATE YOUR BUISNESS! THIS IS WORKING CAPITAL!!! In order to operate your business at the current level of activity, in addition to the investment in PP&E, you will need to invest or borrow $100 for a period of 10 days.

Obviously in a real business, these transactions are happening continuously, but hopefully you can derive some insight here. If you plan to grow sales, you will have to buy more materials and spend more money. So you will have to be able to finance a larger amount of purchases. If your larger, more cantankerous customers are slow in paying bills, then you will have to finance the larger amount for longer. If the store is feeling generous and offers you 60 to pay instead of 30, then perhaps you will get your money from customers before you even need to pay the store! Negative NWC! This is in fact what Dell Computer has been able to do - in a steady state, they require no working capital at all as their customers essentially finance the operation. This isn't the norm though, as usually a business will usually have a positive value for NWC that will require financing for a certain period of time.

Hopefully, this has helped you, although I get the feeling you stopped reading after the second paragraph. "This shit's too long, man. I'm gonna go play some Halo."

4/23/11
jhoratio:

OK, let's serve some lemonade. Wait - we have no fucking lemonade to serve! This is a problem indeed! Now, will the fucking lemonade fairy come down from the sky with fresh cups of lemonade for you sell or do you think you'll have to go shopping again? ....I'll wait for you...no, I'm afraid that's not correct, you will in fact have to make some additional purchases if you plan on making any money. No one is going to pay you just so you can smile at them standing in front of your sign.

.....
Hopefully, this has helped you, although I get the feeling you stopped reading after the second paragraph. "This shit's too long, man. I'm gonna go play some Halo."

Silver banana for delivering a highly entertaining and clear description of working capital. This is what makes WSO go round.

Thanks

4/23/11

haha this was hilarirous..

WC is basically your ability to charge people for your product/service, and get paid from them as fast as possible, and reconcile your A/R/Inv balance etc, while on the liabilities side, your goal is to take as long as possible to pay money back to your suppliers for the the product/service they sold you to create your product/service that you deliver to your customers.

This is a very boiled down explanation, because your CA/CL accounts have far much more detail than what I explained, i.e. debt financing/accruals and shit like that, but I hope you get the general idea. Collect cash from your customers as fast as possible, pay cash out to your suppliers as slow as possible.

4/23/11

In terms of cash flow modeling, Working Capital is important in terms of CASH inflows / outflows, as the the P&L statement might be too quick / slow to realize these adjustments.

I.e. Inventory + AR - Liabilities really matters when we think of a CHANGE in WC. If WC increases in a period (say, quarter), that means that we've made an overall INVESTMENT in that period and our cash should go down by that amount. Why is it an INVESTMENT?

Well, if our inventory goes up, that means we've bought more shit (i.e. raw materials, goods, etc.) that we haven't yet reflected in the COGS for the period. This shit will hit the COGS only when we actually sell this shit. So if it goes up, that means on a net basis we've BOUGHT more materials / and that increase needs to be subtracted to reflect the cash flow.

If our AR goes up in a quarter, that means that on a NET basis we've sold more shit ON CREDIT (i.e. didn't receive the cash for our revenues). An increase in AR decreases our cash flow (because the revenues in the P&L that trickle down to the Net Income include ALL revs in the quarter - the ones sold on credit as well). Keep in mind that in any given quarter we RECEIVE cash for the prior quarter's sales. That decreases our AR. However, if on a NET basis our AR increases, that means that overall we sold more shit credit, and whatever cash we received for the prior quarter isn't enough to offset.

If our payables go up, that works opposite of AR - meaning that we incurred some operating cost but opted to actually pay with cash for it LATER. Increase in payables on a NET basis INCREASES our cash flow. But if it decreases, that means on a net basis we've PAID OUT more liabilities than we've incurred of costs - i.e. we paid down some of our liabilities from previous quarters. That's supposed to decreases our cash.

That's why on the cash flow statement you see this "Change in assets and liabilities" section at the bottom of the operating activities section. It usually includes other changes in current assets / liabs, not just AR, Inventory, AP - and the point here is to adjust the P&L for cash purposes.

4/23/11

WOW...

If you ain't buy side what are you doing on Wall St.? Gimme something good sport...

4/23/11

Working capital is the sweat-soaked 1-dollar bill stuffed right there in a strippers ass crack

4/23/11

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.

4/23/11

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.

4/23/11

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.

4/23/11

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.

4/23/11

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.

4/23/11

Well, it really doesn't matter if you think about it. If you're adding $1 million to all periods, the change is unaffected.

For the purpose of understanding the concept... it depends. I'd typically assume the minimum cash balance is the cash needed to run the business, thus include it in the working capital calculation (most businesses need a certain level of cash to ensure they are able to run their business and don't get bitten by things like receivables, payables, and simple, day-to-day expenses), but I've also seen models where minimum cash balance is nothing but a "show me" type item and not included in working capital. If you have insight into the minimum cash balance and it really is a good proxy for the cash needed on the balance sheet to operate the business day-to-day, include it in working capital. If it's just a number you pulled out of thin air, I wouldn't include it.

4/23/11

Thank you for your response. Yes you are absolutely correct that it does not make a difference on the enterprise value as we are only concerned with the change in net working capital from year to year HOWEVER when using this figure further to get to the equity value of the firm I need to make a decision if I should define Equity value to be:

Equity=Enterprise value-Debt+ All Cash

or Should I define it to be

Equity=Enterprise Value - Debt + Excess cash ( All cash - minimum cash requirement)

Now from a PURELY CONCEPTUAL PERSPECTIVE, If i use the latter equation then i need to recognize the "role" of this minimum cash balance as an operating asset to render completeness to this valuation exercise, but which further complicates things is that it gives me two differnet values for the Equity portion of the firm using the two different equations, it is as if this minimum cash balance serves to lower the equity value of the firm and act as a pseudo debt!

Would love to get your perspective on this! Many thanks!

jimbrowngoU:

Well, it really doesn't matter if you think about it. If you're adding $1 million to all periods, the change is unaffected.

For the purpose of understanding the concept... it depends. I'd typically assume the minimum cash balance is the cash needed to run the business, thus include it in the working capital calculation (most businesses need a certain level of cash to ensure they are able to run their business and don't get bitten by things like receivables, payables, and simple, day-to-day expenses), but I've also seen models where minimum cash balance is nothing but a "show me" type item and not included in working capital. If you have insight into the minimum cash balance and it really is a good proxy for the cash needed on the balance sheet to operate the business day-to-day, include it in working capital. If it's just a number you pulled out of thin air, I wouldn't include it.

4/23/11

I'm not sure I fully understand your last paragraph, but I'm confident that your second equation is the more commonly used one.

The minimum cash req takes from Equity only in the sense that there is less money freed up for shareholders. I wouldn't go so far as to say it's a "debt"

4/23/11

"Implications on M&A: The common commercial definition of working capital for the purpose of a working capital adjustment in an M&A transaction (i.e. for a working capital adjustment mechanism in a sale and purchase agreement) is equal to:

Current Assets - Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus assets and/or deposit balances."

Straight copypasta'd from wikipedia, bro. Increase AR means (positive) increase in WC, so you subtract that out to get FCF

4/23/11

The actual equation for FCF is
FCF = EBIT * (1-T) + d&a -capex - increase in WC,

In this case WC=CA - CL so if Acc. Rec. goes up, WC goes up which reduces FCF because "increase in WC" is positive.

4/23/11

Pretty basic. You're overthinking it.

FCF = NOPAT + D&A - Capex - "INCREASES IN NWC" (don't use the term 'change' in NWC. It's confusing)

NWC = current op assets - current op liabilities

If accounts receivable increases and all else remains equal, that is an increase in NWC, correct?

Therefore... FCF decreases by the amount accounts receivable increased.

4/23/11

.

4/23/11

thanks guys..... yes, I was overthinking it!!!

4/23/11

[x]

4/23/11

Depends on the company...if provisions are tied directly to the business, then I'd say yes. There's no strict definition.

Is it even such a meaningful number that it matters?

4/23/11

Also curious...

4/23/11

*its not it's
sorry for being a grammar nazi but this one really pisses me off

To the starving man, beans are caviar

4/23/11

philosophizingphilosoraptor:
*its not it's
sorry for being a grammar nazi but this one really pisses me off

so obnoxious

4/23/11

What kind of company is it? Different industries have totally different working capital requirements. However, assuming it is zero is a bit suspect. Usually, when getting to FCF in a DCF the cliche is 'fund the growth' when it comes to changes in NWC. Very hard to grow a company without increases in NWC. Unless, of course, the company is managing its WC poorly (i.e. too much inventory, not effectively managing AP and AR, etc.).

4/23/11

certain industries have minimal WC that is not core to the business model such as traditional asset managers and pre-production oil welling/mining companies.
but if you're talking about a company in a more typical industry like consumer, TMT, etc then assuming 0 WC is definitely suspect.

4/23/11

common is business services type companies.

4/23/11

It is a retail company. I do understand that a business, if being run efficiently, should be running at close to 0 NWC requirement. I also found it suspect, but, theoretically, NWC (with the removal of cash and short term securities from its calculation) should not impact a firm's valuation!

4/23/11

Depends on the company and it really depends on your other assumptions. If it's a retail company and you are assuming growth in sales, the company would likely have to invest in WC and therefore have less cash available to distribute / reinvest.

4/23/11

With respect to the effect on FCF, it's -dCurrent Assets + dCurrent Liabilities... you can calculate it yourself from the B/S... If you want to calculate dNWC then subtract that from CF then just reverse the signs.

4/23/11

Yeah I would just refer to the BS. Keep in mind NWC excludes cash.

4/23/11

Exclude cash and cash equivalents as well as notes payable and the current portion of long-term debt. Cash and cash equivalents are excluded because a change in cash is what you are trying to calculate. Notes payable and the current portion of long-term debt are excluded because they are liabilities with explicit interest costs that make them financing items rather than operating items.

4/23/11

mrchow:

Exclude cash and cash equivalents as well as notes payable and the current portion of long-term debt. Cash and cash equivalents are excluded because a change in cash is what you are trying to calculate. Notes payable and the current portion of long-term debt are excluded because they are liabilities with explicit interest costs that make them financing items rather than operating items.


Are short term investments considered cash equivalents?
4/23/11

Depends on liquidity, but generally yes if cash like (eg government bonds) Also depends if there's a cash equivalents definition or just cash.

"After you work on Wall Street it's a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side." - David Tepper

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