Change in net working capital and interest and tax expenses

Ok, so I calculate net WC as current assets - current liabilites. Cash IS included in current assets, as it should be. Change in net WC is obviously just the delta between two years.

My question is this: when you pay interest and taxes, I understand that they show up on the income statement, but does the cash account on the balance sheet go down too, thus impacting the change in net WC? And if the cash account does not change for interest or tax expenses, why not?

Finally, how does this impact the FCFE calculation:

FCFE = Net Income + D&A - Capex - Change in net WC?

I realize the forumla is correct but for the (stupid) life of me, I can't understand how tax and interest expense are not being double counted if they are also reflected in the change in net WC?

Thanks

 
abcx:
Cash IS included in current assets, as it should be.

There's your problem - don't include financial assets (or liabilities) in working capital - i.e. cash & equivalents, short-term debt and current maturities of LT debt should be excluded from your NWC calculation.

 
DaCarez:
abcx:
Cash IS included in current assets, as it should be.

There's your problem - don't include financial assets (or liabilities) in working capital - i.e. cash & equivalents, short-term debt and current maturities of LT debt should be excluded from your NWC calculation.

Why are those things not part of WC?

I thought it was just current assets and liabilities, though you're saying its only CERTAIN ones...why are only some current asset and liability accounts included?

 

Think of NWC as the investment required to sustain a given level of business, be it receivables (investment in customers), or inventory, offset by payables etc.

Cash and financial liabilities (debt) aren't included because they aren't required to sustain that level of operations. This is also known as non-cash working capital - it only makes sense to exclude debt if you're going to exclude cash.

 
DaCarez:
Think of NWC as the investment required to sustain a given level of business, be it receivables (investment in customers), or inventory, offset by payables etc.

Cash and financial liabilities (debt) aren't included because they aren't required to sustain that level of operations. This is also known as non-cash working capital - it only makes sense to exclude debt if you're going to exclude cash.

By "a given level of business/operations" do you mean a certain sales volume?

And in a model, when you're forecasting WC, does it matter whether a company uses only A/P to finance inventory, as opposed to using a combo of cash and A/P to finance inventory? Will that affect your WC ratios (e.g. AP Days) historically, or your forward projections?

And would the only way to increase NWC be to increase receivables (I'm assuming inventory and A/P offset each other equally)?

WC really pisses me off. For some reason it's very unintuitive to me and never fully resonates, but it seems like it should be simple.

 
Best Response
swagon:
DaCarez:
Think of NWC as the investment required to sustain a given level of business, be it receivables (investment in customers), or inventory, offset by payables etc.

Cash and financial liabilities (debt) aren't included because they aren't required to sustain that level of operations. This is also known as non-cash working capital - it only makes sense to exclude debt if you're going to exclude cash.

By "a given level of business/operations" do you mean a certain sales volume?

And in a model, when you're forecasting WC, does it matter whether a company uses only A/P to finance inventory, as opposed to using a combo of cash and A/P to finance inventory? Will that affect your WC ratios (e.g. AP Days) historically, or your forward projections?

And would the only way to increase NWC be to increase receivables (I'm assuming inventory and A/P offset each other equally)?

WC really pisses me off. For some reason it's very unintuitive to me and never fully resonates, but it seems like it should be simple.

Cash and debt relate to the financing of the company, not the operations. If you have a billion dollars of cash on your balance sheet, you could always pay that back to shareholders in a dividend - it's not really a part of operating the business.

When you're thinking of WC and FCF, you want to think about it in a capital structure-agnostic way, so you don't include cash/ST investments or any debt.

 

Taxes and interest expense are reflected in NI which is the beginning of your CF statement, so as taxes and interest expense rise, your cash will go down. Then you need to add back Depreciation because it represents an expense you didn't actually pay cash for, and CapEx represents a cash investment that has not been reflected yet in the I/S, thus not being captured by your NI and not decreasing cash by the appropriate amount (this would leave your assets too high as PPE would rise and not be offset by a decrease in cash). You need to understand conceptually how changes in WC are calculated, think about if A/R goes up by 100 from 2008-2009, this would illustrate that 100 of your NI was not collected in cash and subsequently was added to A/R. As of now this is not reflected in your cash amount so you need to subtract 100 from NI. Also think about A/P going down by 100, this would mean you paid down A/P by an extra 100 which is not reflected yet in the I/S so you need to subtract this from cash. Hope this helps...

 

Ok, so am I right in phrasing it the following way? If you leave cash and debt out of the NWC calculation, you are getting an estimate of the "float" required by the business, whereas if you include them, you get an estimate of the capital deployed at any given time by the business.

Now going back to my question about FCFE, the underlying issue is still nagging at me: let's assume cash IS included in your NWC calcualation. Will Delta NWC reflect your tax and interest expense or not?

I think Damodaran's page is helpful, BTW, if others are confused like me. http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/noncash…

 

regarding your first question, i have no idea. what you are saying doesn't mean anything to me. what does "deployed" mean? how is the cash sitting in your bank account deployed? don't even bother thinking about this. just remember that for the purposes of valuation and free cash flow calculations, you don't need to include cash or debt in working capital

regarding the second part of your question...yes, man. interest expense and tax expense will reduce net income on the income statement, which then flows to the top of the cash flow statement. therefore, assuming interest expense and tax expense from income statement are cash charges (in some cases they aren't), interest expense and tax expense will reduce cash flow. cash flow is reflected on the balance sheets as a decrease in the cash account from one year to the next. so if you include balance sheet cash in NWC and then look at the change in NWC, change in NWC incorporates the change in the cash balance which is just the cash flow from the cash flow statement which incorporates net income which incorporates the income/tax expenses.

cash flow is the change in the cash balance. it doesn't make sense to try and calculate cash flow by adding the change in the cash balance.

[quote=abcx]Ok, so am I right in phrasing it the following way? If you leave cash and debt out of the NWC calculation, you are getting an estimate of the "float" required by the business, whereas if you include them, you get an estimate of the capital deployed at any given time by the business.

Now going back to my question about FCFE, the underlying issue is still nagging at me: let's assume cash IS included in your NWC calcualation. Will Delta NWC reflect your tax and interest expense or not?

I think Damodaran's page is helpful, BTW, if others are confused like me. http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/noncash…]

 
bankbank:
regarding your first question, i have no idea. what you are saying doesn't mean anything to me. what does "deployed" mean? how is the cash sitting in your bank account deployed? don't even bother thinking about this.
Sorry, I meant deployed in the business instead of by it. Anyway, I think I understand it now.

Thanks for all the replies.

 

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