Subtracting change in NWC to get FCF
Hi everyone, I'm trying to learn accounting and was hoping for some help on a question.
If working capital is just current assets - current liabilities, then can someone help explain how change in NWC is needed to get to FCF in the following scenario?
A business sells some inventory (listed at cost as $50 on balance sheet) for $200 (buyer pays in cash at point of sale). No CapEx, taxes, or other costs for simplicity, and balance sheet was 0 assets and liabilities in prior year.
EBITDA is $200. Working capital has increased by $150 ($200-50). FCF by this formula is thus $50.
However clearly the business generated $150 in net cash.
Would really appreciate it someone can explain my misunderstanding!
You're mixing cash and accrual accounting methods. In cash accounting EBITDA would be 200 and the inventory would have been expensed immediately in the prior period (wouldn't sit on the balance sheet). NWC isn't applicable here.
In accrual accounting, the cost of inventory would be recognized at the time of sale. EBITDA would actually be $150 but the sale generates $200 in cash for this period. Prior period operating cash flow would be ($50) for the purchase of inventory.
This was very helpful, didn't realize I had completely mixed up some concepts there.
I see you said this all supposed to be in one period. I'll break it down by transaction instead on accrual basis
Purchase of inventory:
-No income statement activity
-Starting cash balance minus inventory purchase (This is your NWC of -$50)
Sale:
-Recognize $200 revenue
-Recognize $50 expense
Thanks for this answer! I was following until the end, as I noticed you didn't account for the cash as a current asset part of NWC:
NWC at start of period: $50 in current assets (inventory)
NWC at end of period: $200 in current assets (cash)
Change in NWC: $150 increase
Net income: $150
FCF = Net income + Change in NWC = $150 - $150 = $0 FCF, but shouldn't it be $150?
Correct - cash is not included in NWC. If you take both entries and combined them, the NWC is 0 for the scenario. I agree FCF is $150.
Think about how the operating statement of cash flows is prepared (specifically the first two lines). You'll quickly see why we shouldn't include cash in the calculation.
Great explanations for a complicated concept when starting out
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