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Table of Contents:
0:00 Introduction
2:45 Part 1: Why We Care About the Change in Working Capital
4:33 Part 2: What is “Working Capital”?
9:56 Part 3: The Change in Working Capital
14:47 Part 4: Working Capital for Best Buy and Zendesk
18:23 Part 5: Is Item X a Part of Working Capital?
21:40 Part 6: Wait, Why Don’t the CFS and BS Figures Match?!!
26:01 Recap and Summary
Lesson Outline:
We care about the Change in Working Capital because a company’s implied value always depends on its future cash flows, and a big component of Cash Flow is the Change in Working Capital.
Therefore, the Change in Working Capital could positively or negatively affect a company’s valuation, depending on its business model and market.
Traditionally, Working Capital is defined as Current Assets minus Current Liabilities, but that’s not how companies calculate it in their financial statements.
A better definition is Current Operational Assets minus Current Operational Liabilities, so we exclude items like Cash, Debt, and Financial Investments.
The meaning of a positive or negative Working Capital depends on *why* it is positive or negative.
The Change in Working Capital, as shown on the Cash Flow Statement, equals Old Working Capital – New Working Capital.
It’s the opposite of what you normally do because Working Capital is a *Net Asset* on the Balance Sheet, and when an Asset increases, that reduces cash flow; when an Asset decreases, that increases cash flow.
For example, imagine that a company’s Working Capital consists of a single line item: Inventory.
If the company’s Inventory increases from $200 to $300, it must have spent $100 of its cash flow to buy that additional Inventory.
Therefore, the Change in Working Capital = $200 – $300 = ($100), so it’s negative and reduces the company’s cash flow.
When the company finally sells and delivers these products to customers, Inventory will go back to $200, and the Change in Working Capital will be $0 once again.
Cash flow will increase not because of Working Capital, but because the company earns profits on the sale of these products.
If the Change in WC is negative, the company must spend in advance of its revenue growth – like a retailer ordering Inventory before it can sell and deliver its products.
If the Change in WC is positive, the company generates extra cash as a result of its growth – like a subscription software company collecting cash for a year-long subscription on day 1.
The Change in Working Capital, therefore, depends heavily on the company’s business model, such as when it collects cash from customers, when it pays suppliers, and when it pays for Inventory relative to product/service delivery.
For Best Buy and Zendesk, we look at metrics such as the Change in WC as a % of Revenue and as a % of the Change in Revenue.
Since the Change in WC as a % of Revenue is quite low for both of them (low single-digit percentages), we know that Working Capital is not that significant for either company.
As expected, though, Zendesk’s Change in WC as a % of the Change in Revenue are much more positive, averaging around 10%, because it is a subscription software company.
We receive many questions about whether various items, such as Deferred Taxes, Income Taxes Payable, and Operating Lease Assets and Liabilities should be part of Working Capital.
The short answer is that you should follow what the company does, and don’t worry that much about placement as long as the item correctly factors into Cash Flow from Operations.
The only point to watch out for is that changes in Cash, Debt, and Investments, should NOT be anywhere in Cash Flow from Operations or the Change in Working Capital. So, if the company does this, remove these items and re-classify them.
Finally, the Change in WC as calculated manually on the Balance Sheet will rarely, if ever, match the figure reported by the company on its Cash Flow Statement.
This is normal due to different groupings of items on the statements, changed accounting policies, acquisitions, divestitures, and so on.
Don’t panic about these minor mismatches – just focus on the overall Change in Working Capital relative to Revenue and the Change in Revenue and make sure it makes sense going forward.
