Help - What happens to FCF when A/R increases?
Why do we subtract the face value of increases in A/R from free cash flow?
Inventory it makes sense. Inventory is recorded at cost, if your inventory is increasing on the B/S, the amount of cash going out the door is how much it cost you to make the inventory, same as the increase on your B/S.
Theoretically, there is no incremental cash going out the door from increases in A/R. There's no cash coming in either, but your cash doesn't change in that scenario.
You can argue that the company is incurring costs to provide the good / service as no cash is coming in the door, but those incremental costs are not the same as the face value of the A/R.
Not a CPA by any means here but I’ll give it a shot:
As far as my understanding goes, free cash flow starts with Income Statement figures, whether it be EBIT, net income, NOPAT or whatever. The IS takes a/r numbers as revenue, even though no cash would have been received yet at the time the balance sheet was made. To get to the actual cash flows, a/r increases would need to be removed because of that. Conversely, a decrease in a/r would result in an increase in free cash flows based on that same principle, a/r decrease means more actual cash flowing in.
But there is "implied" cashflow making it's way into FCF (and EBITDA and NI) by way of booking accrued revenue that would need to get backed out.
Dr: Accounts Receivable $100
Cr: Revenue $100
To put it in another words, adjustments that need to be made due to changes in NWC aren't just to add back in cash - you need to adjust for / back out cashless revenues and expenses that are already embedded in Sales or COGS due to services being rendered or goods having been delivered (but for which cash has not be received or disbursed)
I believe the 2 comments above answered your question well. If you think of changes in A/R and A/P as positions correcting the NOPAT, things start to get a bit more clear. I think NWC is one of those things which seem really basic to people who understand it, while people being insecure about certain aspects of it shy away from ever diving deeper. While it's less complex than many other aspects of (corporate) finance, I wish it had a more prominent position in valuation classes - think of how important net debt seems, but implications of fluctuations in NWC are as important in M&A
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