Hey guys,
I'm working on a valuation for a company but have some questions. The company I am reviewing is a low capital intensive company. The change in net working capital is negative year over year because the company has over 70% of it's current assets in cash and equivalent.
I've looked around and found some people saying that you amend the FCFE formula to reflect the negative change in net working capital by doing the following:
Net CapEx - (- Change in Net Working Capital) (Essentially adding Net CapEx and Net Working Capital)
What would be the best way to proceed and why?
The second question I have is also related to how to handle the negative change in Net Working Capital when using the reinvestment rate formula. Do you also change it from being negative to positive? Because if you keep Net Working Capital negative and it is larger then the Net CapEx you'll get a negative reinvestment rate.
Any help is really appreciated. Thanks in advance!
Numbers that I'm working with:
Change in Net Working Capital (Non Cash) Yr 1: -2,572
Change in Net Working Capital (Non Cash) Yr 2: -3,020
Change in Net Working Capital (Non Cash) Yr 3: -4,301
Change in Net Working Capital (Non Cash) Yr 4: -6,271
Net CapEx Yr 1: -477
Net CapEx Yr 2: 125
Net CapEx Yr 3: 475
Net CapEx Yr 4: 4
Net CapEx Yr 5: 101
Not sure you understand what you're asking. Why don't you post a numeric example?
A negative change in the NWC is a burn thru of cash, therefore you subtract it. Why? Because the working capital requirements have increased (increased inventory, receivables or reduced payables) and you usually look at the change as Y1 - Y2, therefore if WC for Y1 is 50 and for Y2 it's 70, change in NWC is -20 therefore you are burning 20 extra cash which flows directly down to FCF.
SonnyZH - thanks for commenting, you confirmed my suspicion.
But then how do we take this into account when plugging it in the equity reinvestment rate? I get a negative reinvestment rate which is understandable. Yet, if the company continues to expand revenues, then the relationship should consistent and not inversed. my understanding could be wrong, can you clarify?
Post an example because you don't understand what you're asking.
You may be getting confused between the net working capital position on the balance sheet (-ve for companies with short receivables and power to push out payables) vs. the cash impact YoY. Or you're saying if you model WC off constant revenue % that growing revenue will increase your -ve NWC? But yea, an example would clarify greatly.
I edited my original post to include some numbers. The change in nwc (non cash) has been negative for the last five years, with each year the number becoming larger.
If this is the case then when I plug in the numbers in the equity reinvestment rate formula I get a negative number
Net CapEx = 101 NWC (Non Cash) = -6,701 Net Income = 7,359 No Debt
Equity Reinvestment Rate :101 - (-6,701)/7,359 = -25.4%
How can I interpret the company is reinvesting nothing (or a negative number) back into its operating assets when revenues continues to grow. Maybe I am not interpreting this correctly...
You seem to be interpreting it correctly, but to confirm, what type of business is this? It may be counterintuitive but there are plenty of companies like this -- think of, for example, a retail company or a software subscription company, among others. Basically, a business that takes in cash faster than it spends it. (Think of a grocery store: They receive cash from customers/credit card receivables within 0-3 days of a transaction, but only pay their employees every 14 days and suppliers every 30-60 days.) So it makes sense that as revenues grow, the change is working capital becomes more negative. Basically, the business can fund its own expansion quite quickly and at an increasing rate, which is why your "equity reinvestment rate" (a metric I've never heard of and which sounds like some BS you're taught in school) is negative. Instead of needing to borrow money from a bank (or issue equity), you're basically borrowing it from your employees/suppliers.
mrb87 I appreciate your response! The metric is something from schoool :)
The company operates grading (authenticating) coins and other related metals/valuables. Often times their clients for services in advance.
Can you also confirm that I'm arriving to FCFE correctly too?
Net CapEx = 101 NWC (Non Cash) = -6,701 Net Income = 7,359
7,359 - 101 - (-6,701) = 9,228
Yes, that makes sense then if their clients pay for services in advance. They would have no receivables and tons of deferred revenue and AP.
Your calculation of FCFE is wrong, since net income will include many non-cash charges (most obviously, D&A), unless it doesn't (but it probably does). Better to just take CFO less capex.
Actually I do add back D&A to Net Income, I just use Net CapEx (CapEx - Depreciation) to reflect it. I see why you use CFO-CapEx as it includes all non-cash expenses....gives a cleaner FCF number.
Thanks mrb87!!!
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