Net Working Capital - Valuation model

To any/all who can advise on a question I have regarding the following, I'd have much gratitude:

I am working out a Valuation model for a theoretical Steel MFG outfit, using a Free Cash Flow - NPV approach to find a value for the firm. I have mocked up financials, and only a small amount of information in the instructions to go off of.

My main issue: after applying the FCFF approach for Free Cash Flow (FCF = EBIT (1-tax) + Depreciation - Inv. in CapEx - Inv. in NWC), I am not sure about 2 things:

  1. NWC: Net Working Capital: I understand this to be the change in Current Assets - Current Liabilities, however, I seem to get a different interpretation of 'Current Assets' depending on where you study it. Shall I include 'Cash' as a portion of Current Assets, considering the business in question is a Steel manufacturer?

  2. Discount Rate: This firm is raising capital, and a VC is evaluating them, and the VC requires a 30% return... Can this be applied as the 'Discount Rate' in the model?

Thanks so Much to all.
I look forward to finally getting some clarification on this.

C.G. Hensel II

Comments (108)

 
Apr 23, 2011 - 7:20am
  1. Cash - do not include cash.
  2. They want a 30% equity IRR (not 30% IRR on the project). Use this as the cost of equity if you have to in discounting the FCFF (and of course when arriving at the discount rate = WACC you would need to include the cost of debt and the target leverage assumptions)

Not all shareholders will want this high a return I guess. So, an alternative approach could be to use the FCFE, and use some exit assumption for this company (probably you meant PE and not VC as this is a steel mfg co, and they would have some exit horizon like 3-7 years in mind)

 
Apr 23, 2011 - 7:42am

Thank you Much,
1. Cash: I will omit cash as a portion the current assets, with respect to the change to Net Working Capital, thank you.
2. The 30%... Yes, I interpret the 30% as a required return on the equity the VC is providing the manufacturer... I was just thinking that, without any indication or direction on the Cost of Debt or Cost of Equity, in lieu of anything specific, I could simply apply the return the VC requires as the 'hurdle rate' (discount rate), in order to see how the value looks...

Im trying to estimate a value via 1. NPV approach, and 2. VC method... I am given an industry P/E of 12x, and I am going to use that multiple in finding Terminal Value in the DCF (NPV), and I will also use that as an exit value in the VC method... The time horizon is 5 years.
Given this, does anything change within your reply? Thanks for the guidance. Very Much appreciated.

vaguefunda:
1. Cash - do not include cash.
2. They want a 30% equity IRR (not 30% IRR on the project). Use this as the cost of equity if you have to in discounting the FCFF (and of course when arriving at the discount rate = WACC you would need to include the cost of debt and the target leverage assumptions)

Not all shareholders will want this high a return I guess. So, an alternative approach could be to use the FCFE, and use some exit assumption for this company (probably you meant PE and not VC as this is a steel mfg co, and they would have some exit horizon like 3-7 years in mind)

Carl G. Hensel [email protected] Candidate, MBA - Class 2011
 
Apr 23, 2011 - 7:56am

Oh, one other question: can changes in NWC produce a negative value? What is the implication there? Once 'Cash' is removed, so current assets )A/R + Inventory) - current liabilities (A/P) = Current Liabilities > Current Assets, thus yielding a negative value...? But what is that telling me?

vaguefunda:
1. Cash - do not include cash.
2. They want a 30% equity IRR (not 30% IRR on the project). Use this as the cost of equity if you have to in discounting the FCFF (and of course when arriving at the discount rate = WACC you would need to include the cost of debt and the target leverage assumptions)

Not all shareholders will want this high a return I guess. So, an alternative approach could be to use the FCFE, and use some exit assumption for this company (probably you meant PE and not VC as this is a steel mfg co, and they would have some exit horizon like 3-7 years in mind)

Carl G. Hensel [email protected] Candidate, MBA - Class 2011
 
Apr 23, 2011 - 8:33am

Doesn't matter that NWC is negative for one year - all it means from a practical perspective is that you have to finance this with either borrowing - or the cash you now have free on your balance sheet.

P.S. what you should be using in your model is not NWC, but changes in NWC. So if NWC is -100 one year and -90 another, the change is + 10, which means you get -10 added to cash (increases in NWC decrease cash)

 
Apr 23, 2011 - 8:52am

Yes, I am using the change between periods of NWC, I am not using the NWC value itself.. I wasn't clear with what I meant, I calculate the Net Working Capital requirement for that period, and then for the FCFF calculation, I use the difference... thanks for clarifying, but that was one thing I had going for me in this!

I think I got it all to work out, thank you very much for your help, I have been muddied down for two nights trying to work through different scenarios, values, calculations, reading differing perspectives on WC... I really appreciate the help.
Thanks again.
CGHII

dazedmonk:
Doesn't matter that NWC is negative for one year - all it means from a practical perspective is that you have to finance this with either borrowing - or the cash you now have free on your balance sheet.

P.S. what you should be using in your model is not NWC, but changes in NWC. So if NWC is -100 one year and -90 another, the change is + 10, which means you get -10 added to cash (increases in NWC decrease cash)

Carl G. Hensel [email protected] Candidate, MBA - Class 2011
 
Apr 23, 2011 - 9:49am

Your NWC question is already answered

You cannot use the 30% to value the whole firm - the rate will be too high to give any meaningful value. You presumably have the interest rate of debt (after all you will need that to get the earnings no. as well to apply the P/E ratio)? In the absence of anything else, you can use that as a cost of debt.
Alternatively, from the FCF no. that you get, subtract the interest payments and principal repayments (if any). You get the free cash flow to equity. Discount this with the 30% to get the equity value and add back the net debt to get the enterprise value

 
Apr 23, 2011 - 6:26pm

Vague,
Well, no, I don't have those figures, I basically was told that a VC wants to invest $18MM in a steel mfg company, there are 10,000,000 shares out, steel companies in the industry are selling for P/E of 12... Then I get a Balance Sheet, and an Income statement (only 'total revenues' less about 6 line items equaling 'total expenses' (rent, cogs, advert, salaries, misc, & deprec... ), after which is Profit/Loss.
A bit more detail is given:
estimate firm value using a 30% tax rate, using the NPV approach and the VC method to estimate the % of equity this VC will require to make the investment - assume the steel company goes public 5 years after the investment, which is made at the end of year 0. The lead Manager representing the VC assumes two follow-on equity offerings of 20% and 10% will be needed. The VC requires a minimum of 30% ROI. Calculate % ownership at IPO, retention ratio, price per share, # of shares and % ownership required at the time of investment.

So, am I completely missing something that's glaringly obvious, that is to say, in my approach, and furthermore, can I deduce those variables that you were mentioning from any of this info?? I didn't think I could, so I used the "Profit/Loss" as an EBIT value, and went from there into the FCF model...

Where am I going wrong???!!!

vaguefunda:
Your NWC question is already answered

You cannot use the 30% to value the whole firm - the rate will be too high to give any meaningful value. You presumably have the interest rate of debt (after all you will need that to get the earnings no. as well to apply the P/E ratio)? In the absence of anything else, you can use that as a cost of debt.
Alternatively, from the FCF no. that you get, subtract the interest payments and principal repayments (if any). You get the free cash flow to equity. Discount this with the 30% to get the equity value and add back the net debt to get the enterprise value

Carl G. Hensel [email protected] Candidate, MBA - Class 2011
 
Apr 23, 2011 - 6:51pm

So, I figured out the NWC, removed that from the( EBIT (1-tax)+ Depreciation), then less the CapEx investment for the period, and I have a way better looking set of FCF's... Negative FCF the first year, and subsequently increasing every year after (with the exception of year 3 w/ a significant investment in PP&E)... I come to year 4, final year of projections, and use the P/E multiple to estimate the ongoing value of the subsequent CF's after Yr4, and add that to the FCF from YR 4... PV all FCF's, along with the terminal value, all at 30% discount rate (reflective of the VC's 30% ROI requirement) and that's giving me a decent looking valuation model and output...

I am a rookie at this, so please tell me if I am being ridiculous with any of the above!! I wanna figure this out!

vaguefunda:
Your NWC question is already answered

You cannot use the 30% to value the whole firm - the rate will be too high to give any meaningful value. You presumably have the interest rate of debt (after all you will need that to get the earnings no. as well to apply the P/E ratio)? In the absence of anything else, you can use that as a cost of debt.
Alternatively, from the FCF no. that you get, subtract the interest payments and principal repayments (if any). You get the free cash flow to equity. Discount this with the 30% to get the equity value and add back the net debt to get the enterprise value

Carl G. Hensel [email protected] Candidate, MBA - Class 2011
 
Apr 23, 2011 - 6:52pm

working capital (Originally Posted: 02/25/2008)

could someone explain to me why an increase in working capital would lead to a decrease in free cash flow?

i know workign capital can be defined as current assets - current liabilities...

isn't one example of a current asset cash? thus if cash increased and all else remained equal, woudln't this be an increase in workign capital... ispo facto also an increase in cash... thus an increase in FCF?

perhaps someone could clarify this for me... thanks

 
Apr 23, 2011 - 6:55pm

I assume you mean working capital, not FCF, correct?

You have most of the working capital categories covered, although 'supplies' would generally be more broadly included in a current asset account such as Prepaid Expenses / Other Current Assets. On the current liabilities side, in addition to Accounts Payable you'll often also have Accrued Liabilities and Taxes Payable / Other Current Liabilities as categories.

 
Apr 23, 2011 - 6:56pm

gotcha, and i guess the logic behind this is if your liabilities are increasing (such as accounts payable), you're not actually spending that cash, so you have more FCF... and an increase in inventories, accounts receivable, etc would translate to using up cash to purchase said items, thus decreasing your FCF... does that sound about right?

and for forecasting FCF, whats a good method for predicting future capex? would you just assume that capex growth is equivalent to revenue growth projections (at least for the purpose of answering in an interview, im sure its more complicated than this in real life, but would using revenue growth figures be an appropriate answer)?

 
Apr 23, 2011 - 6:57pm

For an interview, assuming capex growth consistent with revenue projections seems entirely reasonable.

Of course, it may be worth asking the interviewer about the historical relationship between revenue and capital expenditures (e.g., some businesses become increasingly more capital intensive as they grow, while others become increasingly less so).

 
Apr 23, 2011 - 6:59pm

Net Working Capital (Originally Posted: 07/10/2008)

My question is whether or not you should include Cash when calculation Net Working Capital in a FCF / DCF analysis. For example, if a company increases its inventory (cash outflow) and increases its accounts receivable (cash outflow), then the Cash balance will decrease accordingly to offset these adjustments. Holding everything else constant from the year before, Current Assets will be the same and effectively so will Net Working Capital. As such, the Change in NWC would be 0 in a free cash flow analysis. However, from a free cash flow perspective, it seems we should include the cash outlfow due to the increase in inventory and AR. What has everyone else been taught?

Ex.
Year 1 Year 2
Cash 100 50
AR 50 75
Inv 50 75

AP 100 100

WC w/ cash 100 100
WC w/o cash 0 50

 
Apr 23, 2011 - 7:06pm

Good post but I don't think the example in the parent is right. The cash outflow going to inventory should be more than offset by the cash inflow from AR (usually or otherwise you're losing money).

So the example would be more like:

Ex.
Year 1 Year 2
Cash 100 50
AR 50 100
Inv 50 75

AP 100 100

WC w/ cash 100 125
WC w/o cash 0 75

Like the post says, I guess you would only count the part of cash in WC.

Maybe the original example could refer to a growing company increasing its inventory, but in that case I would think a growing amount of cash would be included in WC.

 
Apr 23, 2011 - 7:10pm

working capital is made up of:

current assets - current liabilities

The current assets portion usually includes: A/R, Inventory
So as you can imagine as any of these goes up, your working capital will go up, but you are not generating any free cash flows. So you are counting these as revenue, but you haven't received the cash (or in the case of inventory you have paid for inventory but it isn't part of COGS because you haven't sold it).

The current liabilities portion is just as it sounds, you can think of it as A/P (any short term liabilities)
As this decreases you are paying off liabilities, therefore your WC goes up, but, again your CF go down (you are using cash to pay debt).

I think this should be enough info, although quite simple...maybe someone better versed in this topic will chime in

Array
 
Apr 23, 2011 - 7:13pm

Let's imagine you're running a lemonade stand:

You sell 100 drinks at $2.5 each: Revenue $250
Each drink costs you $1 to make: COGS $100
Permit cost and colorful sign on the corner: $25
Depreciate your lemonade stand: $25
Operating income: $100
Pay taxes at 35%: $35
Operating income net taxes: $65
Add back depreciation: $25
Cash flow before capital needs: $90

I assume you're still with me at this point. You made some money, had some expenses, paid taxes on your income and added back non-cash expenses. This is the cash your business has generated before we consider any capital expense.

Assume you pay all your bills in cash and don't have any payments outstanding. Assume also that everyone pays for their drink when they drink it. Thus AR and AP are zero, but more importantly, they are equal so they cancel each other out.

Let's say you expect business to kick up over the next year. You need to buy an new ice cooler (capital expense) to stock more ice. This costs $15. You used to keep 100 cups on your stand before running across the street to get more. You don't think you'll have time to run around buying cups for all the new customers. So you plan on keeping 200 cups at the stand. You're increasing your inventory by 100 cups. 100 cups costs $25. Where did you get the cash for these $40 in PPE and inventory? From your business! You have to subtract your investments from your cash flow. You made money, and you spent money. What did you spend it on? You spent it on cups and a cooler.

So your FCF is $90 - $40 = $50

Working capital is an investment like anything else. It requires cash.

 
Apr 23, 2011 - 7:15pm

jhoratio thats a good example... but you would't subtract the cost of the cups/inventory from CFO... just the ice cooler. The change in, and cost of cups (inventory) are already baked into your delta in W/C.

So [CFO - CapEx] would be $90-$15 = $75 FCF

edit: econ you have to subtract/add the change in W/C to get to CFO, which you need to get to all other FCF measures.

Follow me on insta @FinancialDemigod
 
Apr 23, 2011 - 7:16pm

Without the accrual method of accounting (i.e., you only record cash transactions), there would be no need to subtract the increase in the change of NWC in your FCF projections. The ONLY exception to this would be an increase in the inventory account, which reflects a cash outlay in inventory. All the other WC accounts are a result of the accrual method of accounting.

There is not much more to it.

 
Apr 23, 2011 - 7:22pm

It's probably better to understand this intuitively.

Cash Flow from Operations (before Working Capital) represents the income statement without any non-cash charges (D+A, etc). That said, suppliers still need to get paid, some customers buy on credit, etc. An increase on the liability side increases cash on hand - an increase on the asset side as the opposite effect.

All in all, you need cash to operate the business. If you don't factor this into FCF, then it isn't "free".

 
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Apr 23, 2011 - 7:30pm

Back to Jhoratio's example, I would expect that inventory is not included because inventory and cash are both a part of current assets, so the increase in inventory when it is purchased would not affect current assets, since inventory increases by the same amount cash decreases. This would not be the case with the ice cooler, which is a part of PP&E.

 
Apr 23, 2011 - 7:31pm

WTF is Working Capital???? (Originally Posted: 09/19/2010)

Please dont tell me to google it, as I've already done it. read tens of websites and I still cant get my head around it. I know WC is a product of inventory, receivables and payables. In other words inventory+receivables-payables=WC. But what does this shit actually mean? (things like WC increases, decreases, etc) I'm looking for some simple explanation here. Your help is much appreciated!

 
Apr 23, 2011 - 7:32pm

What?

It's Current Assets - Current Liabilities.
'Current' means lasting for a year or less, or the 'operating cycle', whichever is longer.

examples of CA: cash (less restrictions), receivables (less allowance for doubtful accounts), inventories, prepaid expenses, supplies
examples of CL: payables, unearned revenue, bonds payable (within a year), interest on bonds payable

The 'operating cycle' is the time between when supplies for making the product are received and when cash for the sale of the product is received.

 
Apr 23, 2011 - 7:33pm

Working capital from a practical standpoint just means stuff that the company needs to buy in order to have a "buffer" during operations. For example if you were operating Apple you would need to sink cash into producing IPhones as an inventory to ensure you don't have stockouts.

Because a company doesn't just buy the initial inventory - they maintain that level for some period of time, working capital is like an investment in time zero, which you can 'sell' at the end of the project life when you don't need the inventory anymore.

Similar premise occurs with other elements of working capital like AR/AP - you don't immediately get paid and don't immediately pay your vendors, so as production and sales ramp up you have a buffer of unpaid and uncollected invoices.

 
Apr 23, 2011 - 7:37pm

You want to be an I-Banker?!?! go to a pizzeria and ask the owner and then multiply his explanation by a couple of billion dollars. You will get a grasp of what working capital is in a big company.

"The higher up the mountain, the more treacherous the path" -Frank Underwood
 
Best Response
Apr 23, 2011 - 7:40pm

warmartinu,

I will answer your question, but know this: just because you "googled it" or "read tens of websites" [sic], doesn't mean you have exhausted your research options. Go to the goddam library and read a fucking book - hopefully one that's more than a paragraph in length. You "read...websites." Congratufuckinglations.

Now, to perpetuate and reward your laziness:

Imagine, as I often ask people to do, that you desire to enter the hypercompetitive soft-drink market by opening up a lemonade stand. What will you need to do this? Do you just stand there like a nincompoop reading tens of websites about it? How will you get lemonade? How will people know you're in business?

First you need a stand. Then some land to put it on. Then a sign so people know where you are. Then a cooler for ice and shelves for other items. These pieces of equipment represent your invested capital. They show up as Property, Plant and Equipment on the balance sheet. To the extent you buy them with your own money or with borrowed money, the claims on those assets are shown as equity or debt. Still with me?

OK, let's serve some lemonade. Wait - we have no fucking lemonade to serve! This is a problem indeed! Now, will the fucking lemonade fairy come down from the sky with fresh cups of lemonade for you sell or do you think you'll have to go shopping again? ....I'll wait for you...no, I'm afraid that's not correct, you will in fact have to make some additional purchases if you plan on making any money. No one is going to pay you just so you can smile at them standing in front of your sign.

You will need to buy cups, water, lemons, sugar, ice. Everything that goes into creating a serving of lemonade. David Ricardo (he is a famous economist who wrote very good books on the subject) talks about the relative "speed" with which capital investments are exhausted, and from here was born the concept of working capital. Basically, working capital is the amount of money you need to operate the business after the investments in fixed assets have been made.

So you go and buy $100 worth of materials. The store gives you a bill and tells you to pay in 30 days. On the 10th day, there's a run on your stand and you use up all the materials selling lemonade making $150. Each time you made a sale, you gave the customer a bill and told them to pay in 30 days. 20 days pass and your bill is due at the supply shop. Hmm, what to do? You sold all your supplies but still haven't gotten any money from your customers. You need to pay the store $100.

Now this may be a cause some unpleasant tingling in your forehead, but let's think about this for a second. The day before the bill was due, your AR was $150, your Inventory was $0 and your AP was $100. So, technically, your net working capital (NWC) was $50. The day after you paid your bill, (AR = $150, Inv. = $0, AP = $0) so NWC was $150. Hey, it went up! What does that mean!? These fluctuations in and of themselves are not very important. The thing to understand is this: if all goes smoothly, there are exactly 10 days that you have to come up with financing for $100 - this is the span of time between when you owe the store and when you get paid by your customers. THIS $100 FOR 10 DAYS IS WHAT YOU NEED TO OPERATE YOUR BUISNESS! THIS IS WORKING CAPITAL!!! In order to operate your business at the current level of activity, in addition to the investment in PP&E, you will need to invest or borrow $100 for a period of 10 days.

Obviously in a real business, these transactions are happening continuously, but hopefully you can derive some insight here. If you plan to grow sales, you will have to buy more materials and spend more money. So you will have to be able to finance a larger amount of purchases. If your larger, more cantankerous customers are slow in paying bills, then you will have to finance the larger amount for longer. If the store is feeling generous and offers you 60 to pay instead of 30, then perhaps you will get your money from customers before you even need to pay the store! Negative NWC! This is in fact what Dell Computer has been able to do - in a steady state, they require no working capital at all as their customers essentially finance the operation. This isn't the norm though, as usually a business will usually have a positive value for NWC that will require financing for a certain period of time.

Hopefully, this has helped you, although I get the feeling you stopped reading after the second paragraph. "This shit's too long, man. I'm gonna go play some Halo."

 
Apr 23, 2011 - 7:43pm

haha this was hilarirous..

WC is basically your ability to charge people for your product/service, and get paid from them as fast as possible, and reconcile your A/R/Inv balance etc, while on the liabilities side, your goal is to take as long as possible to pay money back to your suppliers for the the product/service they sold you to create your product/service that you deliver to your customers.

This is a very boiled down explanation, because your CA/CL accounts have far much more detail than what I explained, i.e. debt financing/accruals and shit like that, but I hope you get the general idea. Collect cash from your customers as fast as possible, pay cash out to your suppliers as slow as possible.

 
Apr 23, 2011 - 7:44pm

In terms of cash flow modeling, Working Capital is important in terms of CASH inflows / outflows, as the the P&L statement might be too quick / slow to realize these adjustments.

I.e. Inventory + AR - Liabilities really matters when we think of a CHANGE in WC. If WC increases in a period (say, quarter), that means that we've made an overall INVESTMENT in that period and our cash should go down by that amount. Why is it an INVESTMENT?

Well, if our inventory goes up, that means we've bought more shit (i.e. raw materials, goods, etc.) that we haven't yet reflected in the COGS for the period. This shit will hit the COGS only when we actually sell this shit. So if it goes up, that means on a net basis we've BOUGHT more materials / and that increase needs to be subtracted to reflect the cash flow.

If our AR goes up in a quarter, that means that on a NET basis we've sold more shit ON CREDIT (i.e. didn't receive the cash for our revenues). An increase in AR decreases our cash flow (because the revenues in the P&L that trickle down to the Net Income include ALL revs in the quarter - the ones sold on credit as well). Keep in mind that in any given quarter we RECEIVE cash for the prior quarter's sales. That decreases our AR. However, if on a NET basis our AR increases, that means that overall we sold more shit credit, and whatever cash we received for the prior quarter isn't enough to offset.

If our payables go up, that works opposite of AR - meaning that we incurred some operating cost but opted to actually pay with cash for it LATER. Increase in payables on a NET basis INCREASES our cash flow. But if it decreases, that means on a net basis we've PAID OUT more liabilities than we've incurred of costs - i.e. we paid down some of our liabilities from previous quarters. That's supposed to decreases our cash.

That's why on the cash flow statement you see this "Change in assets and liabilities" section at the bottom of the operating activities section. It usually includes other changes in current assets / liabs, not just AR, Inventory, AP - and the point here is to adjust the P&L for cash purposes.

 
Apr 23, 2011 - 7:47pm

DCF Net working capital question (Originally Posted: 10/05/2010)

I've been working on a model for a newer, very high-growth company that sells protective coverings for electronics. Basically, when calculating free cash flow to the firm, if I change my assumption regarding an increase in NWC by only 1%, my FCFF decreases by almost $1 mm (about a 25% decrease for this company).

Is it normal for this to happen for newer very high-growth companies? Should net working capital growth be pretty much in line with sales growth, and should it have such a major impact on FCFF in this company's case?

Thanks for any help/advice you can offer.

 
Apr 23, 2011 - 7:50pm

First off what are you driving your NWC off of? I don't have a ton of experience modeling small companies but I've always driven it off days payable and days receivable. If they're generating rev's or shipping product this should be your growth metric. Unless you've been told to drive WC as % of sales this is how you should do it.

Also, when margins are slim your bottom line is extremely sensitive to expenditures i.e restaurants; that could be another reason.

Ace all your PE interview questions with the WSO Private Equity Prep Pack: http://www.wallstreetoasis.com/guide/private-equity-interview-prep-questions
 
Apr 23, 2011 - 7:51pm

I normally drive it off of DSO / DPO, but this is for a class and the professor has given us a very specific template... we're not even supposed to drive the NWC off of sales, we are cutting right to the chase and driving the change in NWC off of sales.

So for example, my historical period is 2007-2009 and the Changes in NWC as a % of sales are 13.6 and 18.8% respectively. In my projection period, I flatlined the change in NWC as a % of sales at 20%.

I know that in a more detailed model you would build out the balance sheet and make assumptions regarding accounts payable / receivable with regards to sales, but in this simple example, I'm not sure if I'm going about projecting the NWC the right way... I've never done it like this.

 
Apr 23, 2011 - 7:52pm

Your model isn't wrong, what it's doing is exposing an unpleasant reality about growing companies. The projections and prospects for a company can be as rosy as you want, but if the company does not know how to manage cash, things will go very very wrong for them very quickly. This is just people operating efficiently and in the real world this is very very hard to do. For most companies that fail, poopr cash management is the reason they fail. Get it wrong just a little bit, and a good business model goes to shit overnight.

 
Apr 23, 2011 - 7:53pm

I've never seen / heard of driving CHANGES in NWC off of sales. With limited info, most comprehensive way to drive NWC is assuming constant A/R days, Inv, days, A/P days, etc from last actual year of financials. After that, I see NWC driven as a % of sales. Driving changes in NWC off of sales vs. NWC off of sales may be why FCF is so sensitive here.

 
Apr 23, 2011 - 7:55pm

DCF Valuation changes in net working capital (Originally Posted: 02/13/2011)

Hi folks,

I have a question with regards to changes in net working capital to be used to calculate the FCF for a firm. I have always used the change in NON CASH net working capital (non cash current assets - current liabilities) as I do not regard the cash as an operating asset to get the enterprise value of the firm via the DCF valuation approach. However if a minimum cash requirement for the firm is provided to you, should I count that minimum cash requirement as a part of the operating cash requirement and Include it as a part of the current assets when I am calculating the change in the net working capital?

For example for a certain year I have the following hypothetical numbers:

Minimum cash requirement: 1 Million

Current Assets:

Cash = 6 Million
Pre-paids = 4 Million
Account Receivables=3 Million

Current Liabilities:

Account Payables= 2 Million

Should the net working capital for this year be 4+3-2 = 5 or should it be 1 (minimum cash requirement) + 4+3-2 = 6

Thanks a lot in advance!!

 
Apr 23, 2011 - 7:56pm

Well, it really doesn't matter if you think about it. If you're adding $1 million to all periods, the change is unaffected.

For the purpose of understanding the concept... it depends. I'd typically assume the minimum cash balance is the cash needed to run the business, thus include it in the working capital calculation (most businesses need a certain level of cash to ensure they are able to run their business and don't get bitten by things like receivables, payables, and simple, day-to-day expenses), but I've also seen models where minimum cash balance is nothing but a "show me" type item and not included in working capital. If you have insight into the minimum cash balance and it really is a good proxy for the cash needed on the balance sheet to operate the business day-to-day, include it in working capital. If it's just a number you pulled out of thin air, I wouldn't include it.

 
Apr 23, 2011 - 7:59pm

Working capital/FCF (Originally Posted: 10/07/2011)

Guys,

I get very confused when asked questions like " what happens to FCF when accounts receivable increases". Can someone please help?

How I think about it is this: increase in accounts receivable means it is a use of cash and thus it should reduce FCF.

HOWEVER, the cause for confusion is the formula for FCF,

FCF = EBIT * (1-T) + d&a -capex - changes in WC,

If it is a use of cash, shouldn't it be subtracting a negative value for WC, which would cause FCF to increase??

Thanks for the help!! Bit urgent, so would appreciate fast responses!!

 
Apr 23, 2011 - 8:00pm

"Implications on M&A: The common commercial definition of working capital for the purpose of a working capital adjustment in an M&A transaction (i.e. for a working capital adjustment mechanism in a sale and purchase agreement) is equal to:

Current Assets – Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus assets and/or deposit balances."

Straight copypasta'd from wikipedia, bro. Increase AR means (positive) increase in WC, so you subtract that out to get FCF

 
Apr 23, 2011 - 8:02pm

Pretty basic. You're overthinking it.

FCF = NOPAT + D&A - Capex - "INCREASES IN NWC" (don't use the term 'change' in NWC. It's confusing)

NWC = current op assets - current op liabilities

If accounts receivable increases and all else remains equal, that is an increase in NWC, correct?

Therefore... FCF decreases by the amount accounts receivable increased.

 
Apr 23, 2011 - 8:08pm

Working Capital and it's effect on valuation (Originally Posted: 12/09/2012)

Formula for fcf takes into account changes in working capital. However, my VP and the CFO of our client company both recently agreed that working capital should be assumed to be 0 when valuing the company as there should be no impact from it on valuation. I wanted to get your guys' thoughts on that.

Thanks

 
Apr 23, 2011 - 8:11pm

What kind of company is it? Different industries have totally different working capital requirements. However, assuming it is zero is a bit suspect. Usually, when getting to FCF in a DCF the cliche is 'fund the growth' when it comes to changes in NWC. Very hard to grow a company without increases in NWC. Unless, of course, the company is managing its WC poorly (i.e. too much inventory, not effectively managing AP and AR, etc.).

 
Apr 23, 2011 - 8:13pm

certain industries have minimal WC that is not core to the business model such as traditional asset managers and pre-production oil welling/mining companies.
but if you're talking about a company in a more typical industry like consumer, TMT, etc then assuming 0 WC is definitely suspect.

 
Apr 23, 2011 - 8:17pm

Change in Net Working Capital (Originally Posted: 09/08/2013)

I'm creating a DCF for Inbev (BUD) and was wondering about the year to year change in Net Working Capital.

I'm pulling the information from Yahoo Finance and I noticed that the NWC for year 2011 (-7,321,000) and 2010 (-3,123,000) are negative while 2012 ($222,000) is positive.

I was wondering if you calculated the 2012 to 2011 change in NWC, 222,000 - (-7,321,000) = 7543000, is that number correct.

The resulting FCF for 2012 is 3,990,000 and 2011 is 15,264,000.

 
Apr 23, 2011 - 8:20pm

Working Capital for Free Cash Flow / DCF ? What Should I Use? (Originally Posted: 05/23/2014)

When you find change in working capital for purposes of finding FCFF what part of the current assets/current liabilities are you supposed to take out. You take out cash but anything else?

 
Apr 23, 2011 - 8:21pm

Exclude cash and cash equivalents as well as notes payable and the current portion of long-term debt. Cash and cash equivalents are excluded because a change in cash is what you are trying to calculate. Notes payable and the current portion of long-term debt are excluded because they are liabilities with explicit interest costs that make them financing items rather than operating items.

 
Apr 23, 2011 - 8:27pm

Technical Working Capital Question (Originally Posted: 06/22/2015)

Hi,

I was recently looking into fogo de chao to see whether it'd be a good investment, and I noticed that, when I started building the DCF, the changes in assets/lianilities stated in the cash flow from operations did not match the subtractions from the balance sheet

e.g.

Change in pre-paid expenses (balance sheet) = 447, while the amount stated in the cfo = 247 (and, no, i double checked i input the numbers correctly). Could anyone briefly explain the difference, and which I should use when calculating changes in NWC? Still a newbie in this...

Thanks

 
Apr 23, 2011 - 8:28pm
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