Change in Net Working Capital Formula

is CA - CL right?
should i include cash while doing dcf?

What is Net Working Capital?

Conceptually speaking, net working capital shows us how much money is being sunk into running the business on a day to day basis that is not being represented on the income statement.

Net working capital (NWC) is calculated as current assets - current liabilities. When examining the changes in NWC, if current assets are rising - the company is investing money in assets such as inventory. These are cash expenses that are not being captured on the income statement in operational expenses. If current liabilities are rising then the company is "gaining cash" in the sense that it has not yet paid for something that it will in the future. These might be things such as wages payable - which is being accounted for as an expense on the IS but has not yet been paid.

You subtract the change in NWC capital from free cash flow because when figuring out the cash flow that is available to investors - you must account for the money that is invested into the business through NWC.

What is Included in NWC?

Current Assets

  • Inventory
  • Accounts Receivable
  • Prepaid Expenses

It is important to note that cash should not be included in current assets.

Current Liabilities

  • Accounts Payable
  • Wages Payable
  • Accrued Expenses
  • Interest Payable
  • Deferred Revenue

Preparing for investment banking interviews?

The WSO investment banking interview course is designed by countless professionals with real world experience, tailored to people aspiring to break into the industry. This guide will help you learn how to answer these questions and many, many more.

Investment Banking Interview Course Here

 
Best Response

if you're asking whether you include cash in the CA to get to change in net working capital, the answer is no. the entire intuition behind CA-CL is to arrive at how cash has changed over the period (increases in CA = use of cash, increase in CL = source of cash)--in that sense, you would use non-cash CA - CL to get to FCF to do your DCF.

 

you include change in cash as a part of change in overall working capital... it still counts as cash that is tied into running the day to day operations of the business. if a company stock piles a ton of cash, you can treat some of it as excess cash and tack it back on after youve completed the entire DCF valuation. cash on hand varies for different companies but having about 3-4 days worth of sales is a good starting point.

 

By definition, Net Working Capital does include cash as it is defined as Current Assets - Current Liabilities. Now, it depends what you want to do with it. If you want to use it as an input in a DCF valuation, which I suspect is the case, cash is usually netted out as we are valuing the operating assets of the company. If you don't have inside info about the company, it's safe to assume that all of the cash is just earning its fair return (cash inestments are zero NPV projects), i.e. it's in the bank. If you have some additional info or extrapolate, you can assume some % as operating cash and the rest excess.

This approach is further reinforced by the fact that to get to the enterprise value you add all the value of all the non-operating assets, of which cash is part.

Hope it helps.

Valuation rules!

 

Maybe in the investopedia.com definition CA for the purpose of NWC includes cash, but for every working purpose CA are net of cash regardless of if you are calculating NWC for CFO or your DCF. If you were to include cash you would be double counting cash in your Statement of Cash Flows (in CFO and beg/end cash balance).

In the DCF, the end result is FCF, so cash from the balance sheet is not a factor. Cash from the balance sheet is indirectly accounted for in your sales, cogs, and expenses.

"This approach is further reinforced by the fact that to get to the enterprise value you add all the value of all the non-operating assets, of which cash is part."

Wrong, in EV, cash is netted out.

 

Sorry, I meant the Change in Working Capital when you calculate the FCF. Normally it's Net Income + Depreciation/Amortization - Capex - Increase in working Capital.

When you calculate your working capital, what do you include/exclude? The way I do it : Current Assets - Current Liabilities - Cash - Short Term debt - Current Portion of the Long term debt.

 

Because holding cash isn't a decision that's directly related to operations, unlike the balances of AR, various prepaids, AP, various accrued liabilities and Inventories. If a company decides to build cash for a transaction, does that mean their NWC requirements have increased? No. If a company spends a bunch of cash on some CapEx, did they suddenly get a lot leaner and more efficient in their use of working capital? No. Thus, cash is excluded.

 

Net working capital items are (1) operations related and (2) short term.

Therefore,

Non-operating cash (aka excess cash) would be excluded. Operating cash would be included.

 

Working Capital = current assets - current liabilities

when you say "NET"

it means net of CASH [we want to see whether the company has enough buffer just thru operational things like accounts receivables/payables and not the cash in its bank account]

and net of current DEBT [we want to remove anything that has to do with coupon payments as these have to do with how the company is capitalized..how much debt it has. If you want to normalize among companies we want to exclude this component so companies are more comparable to each other]

If this is helpful or you want more commentary, find me on my website

 
peterjackson:
Working Capital = current assets - current liabilities

when you say "NET"

it means net of CASH [we want to see whether the company has enough buffer just thru operational things like accounts receivables/payables and not the cash in its bank account]

and net of current DEBT [we want to remove anything that has to do with coupon payments as these have to do with how the company is capitalized..how much debt it has. If you want to normalize among companies we want to exclude this component so companies are more comparable to each other]

If this is helpful or you want more commentary, find me on my website

I understand what to do with cash and financial debt now. Thanks

But, what do I do with the following items in the case of a retail company? current liabilities:. tax liabilities, VAT payables, accruals and deferred income, currents assets: prepayments and accrued income

Thanks R

 

I can see how you can think is possible for it to be a source but its definitely a use. Depending on how much working capital you have whether negative or positive determines you ability to pay down short term debt.

You give me a gift? *BAM* Thank you note! You invite me somewhere? *POW* RSVP! You do me a favor? *WHAM* Favor returned! Do not test my politeness.
 

First, Im assuming you know W/C = Current Assets - Current Liab.

Second, seems like you may be referring to the CHANGE in working cap. this is whats important in the context you're speaking of. example: w/c was $20m in 2009, w/c was $25m in 2010, therefore there is a $5m CHANGE in w/c.

When w/c increases, its considered a USE of cash. This should be pretty logical. Looking at the above example, the $5m change in w/c is considered a use.

Typically, a growing business will have an increasing w/c as their sales increase...basically means that you'll have a use of cash during growth periods.

 

decreasing inventories = source of cash increasing inventories = use of cash

decreasing receivables = source of cash increasing receivables = use of cash

decreasing payables = use of cash increasing payables = source of cash

.... hence net working capital (I+R-P) could be a source of cash if you decrease your inventory/receivables or increase your payables.

 
jack_donaghy:
Considering all cash to be excess is very aggressive. If a company needs $50m in cash and you exclude it, then the buyer will need to pony up the operating cash or the buiness won't work out too well.

I agree. Correct me if I am wrong, but I believe you would actually estimate the excess cash (% of sales) and then exclude that from the Working Capital calculation. Apologies for the confusion.

 

Think of it in terms of the cash conversion cycle, how many days does it take you to sell your inventory, collect cash from customers and pay your suppliers. For example, if I can sell my inventory in 30 days, collect cash from my customers in 30 days but stretch paying my suppliers to 60 days I am effectively using my suppliers as a source of financing. Whether or not this is a good thing will depend on the industry. For example, in retailing, having negative working capital is not unusual and can be a major source of cash. Also, having cash tied up in inventory is a drag on returns, hence manufacturers often use just in time inventory stocking to make better use of cash.

 

Disregards cash conversion cycle, current ratio, and working capital definition.

Look at the moving part of current asset and draw Conclusion.

If components of current asset, such as AR and Inventory is building due to customer defaulting or just delaying making a payment or products not selling, I don't care if WC is 2,3,4 or positive NWC, it's Function as a liquidity ratio shows very distorting picture. If anything meaningful, it means lots of capital is being tied up and less cash is available for other strategic cash flows, such as M&A div share buy back.

Besides are you going to have a access to confidential report such as a aging of AR AP Inventory cash flow projection? No!

I think your question could be framed much better.

 

Well cash is not included in working capital:

Change in A/R: 247-297 = - 47 Change in A/P: 222 - 186 = 36

Receivables suck up 47 in cash and payables generate 36 in cash. Should be a change of -12 in cash over the period just from working capital. Other things (investing and financing activites) will affect cash balance as well. If he got 11 then I am assuming there is a rounding error somewhere.

I guess technically one would since NWC = CA - CL, but my guess is that if you're looking at "net working capital", you wouldn't include cash. The equation is meant to describe the capital needed for a business to run it's daily business operations and one isn't using ALL of their current cash on hand to run the company. I could potentially see including some of the total amount of cash needed because some of it is used day-to-day, but I think that including all cash (including excess reserves) would overstate one's working capital by making it seem higher than it actually is.

I'm no expert though so someone correct me if I'm way off the mark here.

 

Just looking at the statement, but it looks like you're not taking into account the Provisions for Doubtful Accounts. This number is increased by 52, against the decrease in AR is 62.9. This comes out the be roughly the 9/10 that you're looking for. Same thing for Inventory and Provisions for Obsolescence just by eyeing the numbers (29.6+78.8 = 108.4, close to 111).

 

That debt is typically the current portion of the LT debt. Working capital's goal isn't to gauge financing, but rather determine your cash surplus or shortfall through traditional operations (AR, Inv, AP, etc.).

Essentially, LT Assets and Liabilities aren't included because they aren't part of your day-to-day operations. Think about them as project-based expenses (i.e. CapEx funded by new debt).

 

All of those different balance sheet line items generally move independently of each other. For example, just because you produce more inventory doesn't necessarily mean that your receivables from customers increase.

It's easier to think about the movements independently and how they affect cash. For example, you have to buy raw materials to create inventory. Your inventory goes up, which increases your working capital. This is a use of cash.

If your accounts payable account decreases, it's because you paid bills. Since it's a liability decreasing, it is also an increase in working capital, or a use of cash.

Hope this helps clarify the issue.

"Once bread becomes toast, it can never go back."
 

I think you are getting hung up on the words "Working Capital" - it doesn't mean, the money you have. You should exclude cash, cash equivs. when using the formula to understand cash changes. For cash purposes, you need to think about the change in Working Capital. So in your example, if nothing changed except your AR increased by $10 bucks, yes your Net Working Capital is higher. However, to check the change in cash, you subtract the increase in NWC for those two periods. So an increase of 10 would be -10 in cash. Also, go back to your basic understanding of movements in AR or AP.. if you made a sale, but didnt collect the cash (increasing receivables) that is a use of cash- or the income you recognized on the income statement wasn't cash income and needs to be adjusted. for AP, if you don't pay someone you owe an expense, you saved the cash, thus creating a source of cash.

 

Hmm maybe I'm beginning to understand.

So for strictly the 'cash flow' aspect of it you have to reverse the actual change in working capital?

On the cash flow statement for example, you can start with NET INCOME and ADD back depreciation/amort etc then the SUBTRACT out the change in working capital?

So there is technically two different meanings for change in working capital depending on your usage of it...?

 

There is only one way to think about working capital changes. It sounds like you're mixing up somewhat separate topics.

The purpose of the cash flow statement is to show the actual cash that the business generated. There are differences between accrual and cash accounting. The differences are all about the timing of cash inflows and outflows. If you have a business that sold a widget for $100, you would show $100 on your income statement as revenue. Why? Because that's what the accountants say. But, just because you made a sale and recognize revenue, doesn't mean any cash actually changed hands. You could make the sale, and book an A/R (not cash). At this point, your A/R would increase but cash would remain the same. In terms of the indirect method of the cash flow statement (move from GAAP income to cash income), you subtract that increase in A/R because it represents income that didn't result in cash. Therefore, if you have millions of dollars in sales that customers don't pay you for, the cash flow statement will reflect that by removing the increases in working capital (A/R).

As was said above, an entire transaction from start to finish will involve more working capital accounts, so the effect will include levels of inventory and A/P. The cash flow statement changes in working capital is the summary of working capital changes that go on during a period in a company. If you wanted to, you could recreate the cash flow statement with just the income statement and the balance sheet. You can do this because, the balance sheet shows the working capital accounts and you can see their changes.

Hope this helps.

 

In est eum et saepe. In enim eos et et eaque et. In et culpa sapiente blanditiis sint corrupti. Necessitatibus sunt modi sit perspiciatis vel natus. Sunt laudantium fuga et nihil.

Voluptatem dolores voluptatum est excepturi sapiente fuga. Dolor eligendi quas corporis ut rem id. Eaque iure dolores sed totam et eum sint. Itaque animi aut deleniti nostrum nesciunt quo aliquam. Dolore ea aut id est est ad ut. Est accusamus sed nesciunt expedita optio aut.

 

Facere deleniti sed ut laudantium. Earum necessitatibus assumenda non. Deserunt iste sed dolore similique.

Deleniti quia fugiat inventore nostrum beatae. Reiciendis odit nisi nesciunt consectetur sed necessitatibus. Tempore minus praesentium sed vel impedit consequatur. Ea impedit tenetur et vel.

Aliquam quia mollitia dolores ipsam. Fuga reiciendis ipsa ipsa doloremque incidunt nulla quia. Velit sapiente explicabo est ipsam.

Labore optio unde quasi illo. Repudiandae occaecati doloribus beatae eos qui. Tempora fuga eum nulla qui rerum consectetur explicabo. Aut saepe animi iusto quis quis.

Career Advancement Opportunities

March 2024 Investment Banking

  • Jefferies & Company 02 99.4%
  • Goldman Sachs 19 98.8%
  • Harris Williams & Co. (++) 98.3%
  • Lazard Freres 02 97.7%
  • JPMorgan Chase 03 97.1%

Overall Employee Satisfaction

March 2024 Investment Banking

  • Harris Williams & Co. 18 99.4%
  • JPMorgan Chase 10 98.8%
  • Lazard Freres 05 98.3%
  • Morgan Stanley 07 97.7%
  • William Blair 03 97.1%

Professional Growth Opportunities

March 2024 Investment Banking

  • Lazard Freres 01 99.4%
  • Jefferies & Company 02 98.8%
  • Goldman Sachs 17 98.3%
  • Moelis & Company 07 97.7%
  • JPMorgan Chase 05 97.1%

Total Avg Compensation

March 2024 Investment Banking

  • Director/MD (5) $648
  • Vice President (19) $385
  • Associates (85) $262
  • 3rd+ Year Analyst (13) $181
  • Intern/Summer Associate (33) $170
  • 2nd Year Analyst (65) $168
  • 1st Year Analyst (198) $159
  • Intern/Summer Analyst (143) $101
notes
16 IB Interviews Notes

“... there’s no excuse to not take advantage of the resources out there available to you. Best value for your $ are the...”

Leaderboard

1
redever's picture
redever
99.2
2
BankonBanking's picture
BankonBanking
99.0
3
Betsy Massar's picture
Betsy Massar
99.0
4
kanon's picture
kanon
98.9
5
Secyh62's picture
Secyh62
98.9
6
dosk17's picture
dosk17
98.9
7
CompBanker's picture
CompBanker
98.9
8
GameTheory's picture
GameTheory
98.9
9
bolo up's picture
bolo up
98.8
10
DrApeman's picture
DrApeman
98.8
success
From 10 rejections to 1 dream investment banking internship

“... I believe it was the single biggest reason why I ended up with an offer...”