Can someone please provide a few resources on understanding the change in NWC and how that relates to valuation and solving for FCF. I understand the textbook definition/use but am trying to develop an intuitive understanding of NWC and what its YoY change means from an operational and valuation perspective. Also is change in NWC added or subtracted when going from Rev to FCF? Most guides say (+/-)?
Thanks.
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Free cash flow is basically how much cash the company has that's available to shareholders / creditors (if unlevered). Thus, if you think about what exactly makes up NWC - receivables, payables and inventories, these are basically items that result in a change in the amount of cash available to the firm. For instance, if a company's inventory increased by 100 in a year, it has to use up 100 in cash to buy it, which means that amount is no longer available during that year.
From a valuation standpoint, you as a shareholder can no longer access this 100 in cash this year (but instead you can only access it in future years after the inventory is sold), which obviously decreases the valuation of the firm because of the time value of money.
From an operational perspective, it's typically a bad sign as well if NWC continues to increase year on year (as a percentage of revenue), because it means the firm is not managing its inventory efficiently or is facing issues with its customers not paying them on time.
As for whether you add or subtract, it's easier if you think about whether the increase is a cash inflow or outflow. Increase in receivables means the company was unable to collect the cash yet (cash outflow), increase in payables means the company didn't pay the cash yet (cash inflow), and buying more inventories uses cash which means cash outflow.
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