Confused over NWC capital part of IB Interview Question
I saw an interview question but I was a bit confused due to the replying comments on it:"A company has $20 of operating cash flow and a change in NWC of ($10), D&A of $5, and Capex of $20. The company has $450 of equity value. What is the P/E Ratio?"
I understand that you ignore the capex because you already have CFO and are looking to work backwards to find earnings. However, the the discrepancy I saw was in the NWC part of the calculation.
Since CFO = NI - change in NWC + D&A,
I assumed the formula used would be NI = CFO + change in NWC - D&A = 20 +(-10) - 5 = 5
However, all the comments said NI = CFO -(-NWC) - D&A = 20 -(-10) - 5 = 25
Can anyone explain the right way and what I'm not understanding here?
I think your problem is just algebra. The sign in the negative NWC flips. You technically adding the change in NWC (either it be negative or positive).
Yes but to work backwards towards NI would you not then take it away?
When bridging to CFFO from NI, you subtract out the change in NWC and then will add back D&A since it is a non-cash cost already baked into your NI. You subtract out change in NWC because if your NWC increases, that is a use of cash. Because the change in NWC here is negative, you are subtracting out a negative amount. $$25 NI is the correct figure.
What you said makes sense. But since I am trying to go backwards (from CFO to NI) would I just not do the reveres of what you just said?
Subtract D&A from CFO and add back the change in NWC that was previously subtracted from NI to get to CFO.
Like you said, the change in NWC here is negative which corresponds with a cash inflow that needs to be added when you go from net income to CFO:
CFO = NI + D&A - (-10) = NI + D&A + 10
To go back to NI, would that $10 not just be subtracted?
NI= CFO - D&A + (-10) = CFO - D&A - 10
Stand correct even if sometimes it means you have to stand alone.
NI + D&A - NWC - Capex = CFO
x + 5 - (-10) - 20 = 20
Isolate and solve for x
5 - (-10) - 20 - 20 = -x
5 + 10 - 20 - 20 = -x
15 - 40 = -x
-x = -25
x = 25
CapEx in Cash Flow from Operations.
How did you make An2 with this level of technicals?
lol youre right - got some serious brain fog
I reread my comment and immediately was like "hold up im a dumbass"
Respectfully, as the village idiot ECM banker, even I know this LOL
why would we not account for capex again? is it because it is under CFI, not CFO?
Yes
Net Income: x
+ D&A: + 5
- Change in NWC - (-10)
= CFO = 20
So, Net Income = 20 - (+10) - 5
= $5
$25 seems wrong here. Change in NWC negative means cash increases. So unless the question had a positive 10 and they wrote it differently somehow, Net Income should be 5.
Starting to realize that the hard way haha
But how do you calculate the P/E ratio once you have calculated the NI?
Market cap / Net income
So equity value of 450 / 5 = 90x.
Pretty high in this case. This might make you doubt the validity of your Net Income answer but that could be part of the trick.
If NWC was positive then NI = 25, and PE would be 450/25 = 18, which is close to normal range for most sectors.
But, tech companies and even growing companies always have high PE in growth phase.
Guys the formula for CF is not "minus ΔNWC". It's "plus/minus ΔNWC". You just ad the change in NWC whatever sign it has. It's not a subtraction by rule.
They tell you ΔNWC is - 10. So on the way to cfo you have subtracted 10. Now when you go back to NI you have - (-10) so you end up adding it back...
This is incorrect. The formula is +/- change in net working capital ITEMS not NWC itself.
NWC = current assets - current liabilities
If the current assets increase, cash goes down (so - for increase in asset items). Similarly, + for liabilities items as cash goes up.
But if ∆NWC as a whole is positive (i.e., increases), it means assets increased by more than the amount with which liabilities increased and hence cash should go down as a result.
And the opposite for if it is negative (cash goes up).
If you are using ∆NWC as a whole, the formula is: CFO = NI + D&A - ∆NWC to account for this fact.
Edit: did you just MS me cause you got butthurt that you were wrong or cause someone else MS’ed you?
I don't disagree with your overall explanation of wc mechanics above. I'm just pretty sure that as a matter of interpretation in the original question they simply say the cf impact is - 10 and strictly speaking you'd have to reverse that as you go back to NI.
It's less about the formulas here as ironic as this might sound
Anyway. Maybe I'm wrong what do I know.
You’re right but I think so many get bogged down in the formula vs understanding what it means… that’s why people mess this up
What is NWC? Cash “tied up” in operating your biz. Cash spent vs cash received in day/day ops of the biz. Ok, so if NWC is $5, that means you “used” $5 of cash to run your biz net/net. If it’s -$5 that means you “got” $5 in cash (either via decrease in current assets like A/R goes down I.e. someone gave you $5 that they owed you or increase in A/P I.e. you owe someone 5 bucks so you have that 5 bucks as cash, etc)
So just think logically. If your OPERATING CASH FLOW is $20, and your NWC is -$10, that means that “in” your $20 number there is $10 that was reflected as a result of your NWC going down. So you have to remove it from the $20 figure. After that, D&A is the same thing. Your OPERATING CASH FLOW includes the BENEFIT of reflecting the cash you DID NOT spend on D&A. So you have to take that out too. $10-5=$5. CapEx has nothing to do with operating your business day to day and is a long term investment, so it shouldn’t be included in the cash you get from RUNNING THE BIZ AND SELLIN SHIT.
Maybe I’m a fucking idiot but when I rely on formulas I fuck up the above 100% of the time vs when I just think through what happening to the BUSINESS. We work in finance, we are not mathematicians. Understand WHY you’re doing what you’re doing and you won’t need formulas (exaggerated a bit, of course)
The fact that responses are all across the board is hilarious for an investment banking forum
if the change in NWC is negative, this means that NWC requirement this year is less than last year. Thinking about what this means, it's saying less cash is required to fund the operations of this business, so cash tied up in the operations was released (cash inflow). Maybe you collected AR faster, were able to pay suppliers later, or moved inventory off the shelves quicker than last period (in any case cash is up). So working backwards from the $20, the NWC cash inflow, and the D&A add-back leaves you with $5 of NI (5 + 10 + 5 = 20).
Fuck the formulas. Just understand what is actually happening in the business and you won't make these errors.
I work in ECM and it’s hilarious that I know this and the coverage bankers who shit on us don’t know this 🤣
Agree don’t think formulas, think logically. Why is net income generally not a good proxy for cash? 1) includes non cash expenses 2) doesn’t account for sources & uses of cash on the balance sheet that already flowed through the income statement (when earned / expensed).
Ok, so if we have $20 in operating cash, to get to net income, work backwards. D&A is obvious. It’s non cash expense reflected in NI but not in operating cash flow. So we need to take that out. $20-$5=$15. Well, what if our accounts payable went up? Means we owe ppl more money. We got cash. Or vice versa, accounts receivable went up? Means we gave people shit but people owe us. We used cash. So, if change in NWC is -$10, that means that, net net, we “got more cash by $10”. This SHOULDNT be in the income statement. So we need to take this OUT of our operating cash. $15-10=$5. Capex is by definition “capital expenditures” I.e. it’s capitalized on the balance sheet and has nothing to do with the income statement as its “benefit” is >1 year.
Net income = $5
Equity value = $450
P/E=90x (lol)
Bro, forget ECM, I am engineering -> MFin -> officially unemployed.
And I am correcting answers of verified bankers, haha.
*verified interns
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