Understanding change in net working capital
Hey guys, I am trying to understand change in NWC and how it relates to the FCF and overall cash position of the company.
As I initially understood it, a higher NWC indicates the company has the capability to pay its current liabilities and thus is in a better position. However, a higher NWC year over year actually means a lower FCF. As I investigated the reasons why, it was explained to me that because a higher NWC means higher current assets that are uses of cash, from the cash flow perspective the net cash flow would indeed be less.
In fact in this blogpost (https://www.oldschoolvalue.com/blog/valuation-met… ) the author gave examples of companies who have increased accounts payable and lowered current assets and talk about how that makes the companies even healthier. While I can understand how ultimately from the cash flow perspective it is indeed better, it still seems absurd to me that (e.g the Apple example) a company with consistently lowering current assets and consistently increasing current liabilities more "efficient". I mean, isn't the definition of an efficient business a company with low payables???
I hope someone could explain this to me in a greater detail. Thank you!
I like to think of accounts payable as a credit card. It’s a current liability that you have to pay off every month in cash. Wouldn’t you much rather pay it off in a year with no interest?
Similarly, think of a current asset like your paycheck. The ideal scenario would be if your pay is siphoned into your bank account as you work with no lag. However, you get paid biweekly, which means you have to wait to get the cash.
Anything that you sell that isn’t going into accounts receivable / current assets is turned straight into cash, which you can use immediately. Any payable that you incur delays the time that you have to hand over cash to suppliers.
Lifestylemna do you have any other examples?
Subscriptions - you’d rather pay for them at end of cycle (I.e. not have prepaid expense sitting in your current assets), but companies rather you pay the cash then have the current liability on their balance sheet
Think of it this way:
NWC, for a FCF purpose, ignores non-interest bearing assets and liabilities & cash. So, as receivables, inventory, etc. increase, cash decreases and as payables, deferred revenue, etc. increase, cash goes increases, so there is increased efficiency from a cash generation standpoint
How quickly a company can turn its revenues/assets into cash not the level of their payables better indicates operational efficiency. For example, a company with an average of 80 days receivables outstanding and 2 days payables outstanding will almost certainly be wildly inefficient because they won't have sufficient cash to service liabilities or fund cap-ex.
As I understood it:
Working capital: Current Assets - Current Liabilities. You want this number to be as high as possible. It reflects how much of my financing is covered with my assets.
Net operating working capital. Subtle difference with the one above. In here you want to substract Current liabilities net of debt to current assets net of cash.
Net working capital: this is basically what you need to keep the business open. You want this number to be as low as possible. Accounts receivable + Inventories - Accounts payable.
Wow thank you.....I immediately understand now. Thanks so much!
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So net working capital (your 3rd bullet point) of 0 is ideal? With anything above or below that implying/signaling what?
yes, as far as my understanding goes as AR and Inventories imply usage of cash and accounts payable sources of cash, you want your sources of cash to cover as much as possible your usages of cash. Basically, the larger the days of AP the better and the lower the days of AR the better. SO basically your suppliers financing your customers. I can dig deeper into this if you wish. Yet again the signalling quite a lot depends on the industry and I will not venture into it because my knowledge is limited, but hopefully, someone can shed some light on the issue.
I'll try to add to this.
You care about Current Assets > Current Liabilities because it represents the business's ability to keep the lights on (as you pointed out, current assets includes cash on hand). I wouldn't go so far as to say an equity holder wants this number "as high as possible". At some point you've reached a certain comfort level that the company can meet its near-term obligations. After that, a higher ratio can run counter to your other working capital management goals.
Your opinion on net working capital depends on who you are. As an equity holder, you generally want this number as low/negative as possible. Negative net working capital is free/cheap financing provided by your vendors, which is capital you don't have to provide! When you start a lemonade stand, you've got to buy the inventory and (stretching the analogy a bit far) extend credit to customers. Wouldn't it be better if your parents gave you the ingredients and told you to pay them back once you collected on your sales? Which do you think gives you a better return on equity? If an existing business can improve (lower) its net working capital, it frees up capital that was once captive and turns it into cash, which it can then return to shareholders or reinvest elsewhere for greater returns.
Debt holders generally take an opposite view of working capital. As a lender, I like the idea that there's capital tied up in the business and it's there for me if the borrower defaults. Plus, as revenues rise or fall, net working capital tends to stay constant as a percentage of sales. This means that for a company with positive net working capital, NWC will grow as sales grow and be a use of cash; but if sales fall (a scenario I worry about as a lender), NWC may (or may not) shrink and free up cash to meet loan obligations. But a company with negative net working capital is the opposite. If sales fall, it needs to pay back its vendors faster than it can collect on its receivables, taking cash out of the business at a bad time.
Account receivables are sales that have not turned into cash yet. A company with lower levels of account receivables than its peers (with similar sales) implies a better cash conversion. A better cash conversion also results in higher free cashflows and a higher valuation. The same logic applies to inventory and for accounts payables (with negative sign)
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