Why Does Working Capital Matter? Many places define it as Current Assets minus Current Liabilities
- that is technically true, but it misses something important.
WHY does it matter? What is the point of this? How do you use it? How does it impact a company's value?
It's really the CHANGE in Working Capital that matters for valuation and financial modeling purposes.
Working Capital, by itself, does not tell you a terrible amount and could mean many different
things... but when you also look at the CHANGE in WC, what it is as a % of revenue and other metrics, AND the company's business model, that's when you start
What Does the "Change" in Working Capital Mean?
Best NOT to use the official definition of Current Assets minus Current Liabilities...
First off, cash and debt should be excluded altogether because they are not operational line items and therefore won't factor in when calculating a company's Free Cash Flow in any type of valuation.
Also, it's easier to think of this in terms of the *individual items* that comprise these Current, "Operating" Assets and Liabilities.
Most Common Current, Operating Assets: Accounts Receivable, Inventory, and Prepaid Expenses.
Commonality: Paid for them upfront in cash or represent cash payments you're waiting on. INCREASING these will cost you cash!
Most Common Current, Operating Liabilities: Deferred Revenue, Accounts Payable, and Accrued Liabilities.
Commonality: You get cash from these! When they increase, your cash flow goes up because you're getting cash in advance (Deferred Revenue) or because you're delaying payments (AP and AL).
So with the "Change" in Working Capital, you're seeing which group of items increases
by a greater amount:
Current Assets Excluding Cash?
or Current Liabilities Excluding Debt?
If this Change is NEGATIVE, then Current Assets are increasing by MORE than Current Liabilities!
Interpretation: Company might be spending a lot on Inventory, might be waiting too long for customer payments, might be paying suppliers very quickly...
If this Change is POSITIVE, then Current Liabilities are increasing by more than Current Assets!
Interpretation: Could be collecting a lot of cash upfront, might have no or minimal inventory, or might just be delaying payments to suppliers.
Examples and Real World Interpretations:
Wal-Mart's Change in Working Capital:
It's always negative due to huge Inventory expenditures - since WMT is an offline retailer, it MUST pay for Inventory in advance before selling it.
It does keep suppliers waiting a fair amount since its AP balance is also high and increasing each year, but Inventory spending outweighs that.
This means that as Wal-Mart's business grows, it requires ADDITIONAL cash to keep growing!
But as a % of revenue, this is very small so it makes a minimal impact. It will reduce the company's valuation in a DCF, though, because this will push down Free Cash Flow.
Amazon's Change in Working Capital:
Amazon's Change in WC, by contrast is positive each year.
It's still spending a lot on inventory... and actually, as a % of revenue the change is higher than Wal-Mart's each year...
BUT it is also not paying suppliers as quickly and is accruing more to the Accounts Payable balance each year.
For WMT, the increase in Inventory exceeds the increase in AP every year... for Amazon it's the opposite! Plus, the Deferred Revenue from customers paying in cash in advance for products boosts Amazon's cash flow.
The end result: for Amazon, the Change in Working Capital boosts its Free Cash Flow and therefore its valuation in a DCF - quite significantly since it exceeds Net Income.
Salesforce's Change in Working Capital:
Salesforce also has a positive Change in Working Capital...
No inventory required since it's a subscription software company!
BUT it still has AR, and Deferred Commissions - must be paid upfront to sales reps in cash and then recognized over term of subscription.
The Net Change still ends up being positive, though, thanks to that huge increase in Deferred Revenue each year... subscriptions are often sold months or years in advance, but the cash is collected UPFRONT.
So as Salesforce grows, it doesn't require additional cash - it actually GENERATES additional cash. This will increase its Free Cash Flow and therefore increase its valuation in a DCF.
Summary - What Does the Change in Working Capital Mean?
As the business grows, does it generate MORE cash than you expect... or it does it REQUIRE additional cash to grow?
Makes a big difference for a DCF analysis when you value a company based on its cash flows, but also makes a difference for how much funding the business needs to grow, and even what happens when that business gets acquired.