In our continuing series on owners earnings, this post will tackle the last difficult line item, changes in working capital. We will discuss what it means, the formula on how to calculate changes in working capital, and finally some real-life examples.
As we work through this topic, please read the page slowly and take your time. Some of the info that we will cover can be a bit confusing, but it is important to understand.
Understanding this topic will give you a great insight into the free cash flow of any company and how to use it as well as where it comes from in the process.
Let’s get started, shall we?
What Changes in Working Capital Means
So what is changes in working capital and what does it mean?
Let’s get this out of the right first.
Working capital is not changes in working capital.
The simple definition of working capital is:
Current assets – current liabilities
Unfortunately, this is a little too simple, and what we are looking for is the how and why of working capital.
According to Investopedia:
“Working capital is the difference between a company’s current assets, such as cash, accounts receivable (customers unpaid bills), and inventories of raw materials and finished goods. And it’s current liabilities, such as accounts payable.
Working capital is a measure of a company’s liquidity, operational efficiency, and its short-term financial health. If a company has substantial working capital, then it should have the potential to invest and grow. If a company’s current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors, or even bankrupt.”
That explains, in a nice and tidy way what working capital is and how it works to help a company grow.
However, we need to look beyond the accounting standpoint and come to an understanding of what the “change” in changes in working capital means.
Beyond a formula or equation telling us what working capital is, the important issue is to understand what the change part means and how to interpret it and to be able to use it in valuing companies.
Difference between Working Capital and Changes in Working Capital
Remember that working capital = current assets – current liabilities.
Working capital is a balance sheet definition that only gives us a value at a certain point in time.
Changes in working capital is an idea that lives in the cash flow statement.
Companies need working capital to survive, to continue with their operations; it is a necessary ingredient. That is the real reason for working capital, its raison d’etre.
Constantly looking at your balance sheet to determine your current assets minus your current liabilities makes little sense as a business owner.
Changes in working capital will help you determine where the business is in its working capital cycle.
Companies will try to shorten their working capital cycle, by either collecting receivables sooner or sometimes extending accounts payable.
This cycle is what all companies strive to shorten as opposed to looking at the balance sheet definition, which defines only one certain point in time.
Operating Working Capital
When we discuss working capital, we need to determine the capital needs of operating the business and the business cycle.
All businesses strive to shorten their business cycle by either collecting on their receivables sooner or extending their accounts payable.
This ebb and flow of their business cycle give them more “cash” to use to operate their business.
When looking at the working capital needs, we need to consider only those items that affect their operating needs.
We could also refer to this as non-cash working capital because the companies current assets include cash, which we need to exclude because it is not used to operate the business.
Let’s take a look at an actual cash flow statement from Oshkosh Corp to use as an example of how we break this all down.
The section that we are going to focus on for the remainder of this post is the Changes in Operating Assets and Liabilities. The section of the cash flow statement is where the changes in working capital live and breathe.
Breaking the sections down by generalities:
Operating part of the asset side of working capital will include:
- Accounts receivable
- Prepaid expenses
- And some uncommon current assets found in the financials
The big point of this section: increasing any of these requires the use of cash, very important point, we will come back to this many times.
Current liabilities are the next section, which will include debt, which is not an operating factor of the business.
Remember that debt is a choice each business will make for financial reasons.
Items that are categorized as operations on the liabilities side of the ledger:
- Accounts payable
- Accrued expenses
- Deferred revenue
- Income taxes payable
- And some uncommon liabilities found in the financials
Increasing any of these liabilities decreases the use of cash, which all companies like, a lot.
We referenced the business cycle earlier, stretching accounts payable and collecting our receivables earlier helps increase our cash available for operations.
Breaking down the “Change”
This section can be a little difficult to understand, so, please read through it carefully and return to it as often as needed.
Most people assume the change in working capital means that you calculate the change from one year to the next via these items from the balance sheet.
The wrong way to do this is to calculate the working capital in year one from the balance sheet, then calculate the working capital in year two from the balance sheet and then subtract to get the change.
Change in working capital is a cash flow item that reflects the actual cash used to operate the business.
To explain this further I am going to quote from Jae Jun, who has written several great articles on this very subject.
“The “change” refers to how the cash flow has changed based on the working capital changes. You have to think and link what happens to cash flow when an asset or liability increases.
If current assets are increasing, cash is being used.
If current liabilities are increasing, less cash is being used as the company is stretching out payments or getting money upfront before the service is provided.
To tie this together, the “change” is about determining whether current operating assets or current operating liabilities are increasing.
If the final value for Change in Working Capital is negative, that means that the change in the current operating assets has increased higher than the current operating liabilities. Cash has been used, and this reduces Free Cash Flow.
If Changes in Working Capital is positive, the change in current operating liabilities has increased more than the part of the current assets. This means the use of cash has been delayed, which increases Free Cash Flow.
Put another way, if changes in working capital are negative, the company needs more capital to grow, and therefore working capital (not the “change”) is increasing.
If the change in working capital is positive, the company can grow with less capital because it is delaying payments or getting the money upfront. Therefore working capital is decreasing.”-Jae Jun, Old School Value
He says that far more eloquently than I could have, and the last two sentences are key to understanding this concept.
Please re-read that section again until you understand the concept of changes in working capital, until you do the calculation part it will not make much sense.
How to Calculate Changes in Working Capital
Calculating the changes in working capital is fairly easy, once you understand the principles behind the theory.
A word of caution, not all financial statements are going to list every line item the same, i.e., not all are going to list every asset or liabilities, and the terminology they are going to use may vary from company to company or industry to industry.
If you are unsure of any line item, my suggestion is to either use our friend Mr. Google or email me (email@example.com), and I will give you a hand unless of course, you have your handy-dandy accounting 101 books laying around.
To calculate our change in working capital, we will take all the items from the assets and add them together; then we will do the same for the liabilities.
Once we have both the assets and liabilities tallied, we can then subtract the liabilities from the assets to arrive at our number for the change in working capital.
The math portion of this calculation is very simple; the harder part is understanding where the numbers come from and why the change in working capital is important, and how to interpret the result.
Next, let’s look at some examples from real companies to find our changes in working capital.
Examples of Changes in Working Capital
For our first example, I would like to return to my old friend, Oshkosh Corp; we can revisit their cash flow statement and look at our calculations.
To review the items from Oshkosh Corp that are assets are:
- Other Current assets
From the current liabilities:
- Accounts payable
- Customer Advances
- Payroll-related obligations
- Income taxes
- Other long-term liabilities and assets
Taking the numbers from the cash flow statement and adding them up we get:
That was pretty easy, just some easy math for a change, and all the numbers laid out all nice and easy for us.
What does this negative number mean? It means that the changes in working capital are negative and that Oshkosh Corp needs more capital to grow, and therefore, working capital is increasing.
Notice one thing about Oshkosh Corp’s cash flow statement; they already do the calculations for you.
Oshkosh Corp lists it as Total Changes in Operating Assets and Liabilities, or changes in working capital.
Not all companies will do this for you; in fact, most won’t do it at all.
Let’s take a look at a few more to help nail down this idea.
Next, let’s take a look at Hormel as we have used them for our owner earnings examples.
First, I will pull the cash flow statement, and then we can go from there.
Now, I will build our chart based on the numbers from above.
Notice the different language for the assets and liabilities; this is where it can get a little confusing and why spending a few minutes to double check our terminology.
Also, notice that we have excluded the net cash at the bottom of the section in the cash flow statement.
The reason for this is we do not use cash in working capital.
Based on our numbers we can see that Hormel has a positive change in working capital number for 2018.
What does this mean? It means that the company can grow with less capital because it is either delaying payments or collecting receivables earlier, which means that working capital is decreasing.
Next up let’s take a look at Verizon, we have used companies that have a strong manufacturing base, whereas Verizon would be far more tech based.
Ok, now that we have our cash flow statement for Verizon we can go ahead and put together our chart.
Again notice the similarities in the language that each company uses when differentiating between assets and liabilities.
As before with Hormel, we are excluding the net cash. We are also not including the employee benefits and other, net as they can’t be included in our liabilities because they don’t contribute to our working capital.
We can see from our chart that Verizon has a negative number in their change in working capital.
Finally, let’s take a look at a financial company to get a sense of how this would work for them.
Notice that the ingredients of the changes in working capital for a bank are a little different, but the concept is still the same.
With a bank, the assets and liabilities are going to be different and may be confusing to some, but if you take a moment and think through how a bank works and what they use their money for you will see it is not all that different.
Those particulars will be a post for another day.
Today I want to focus on how the changes in working capital work and that we understand the concept.
As before with the above examples, JP Morgan has a negative change in working capital, which indicate they will need to raise additional capital to grow the company.
We have covered a lot of ground today, we have discussed the particulars of changes in working capital and what they mean for our business.
The key is to remember how the positive number and negative number correspond to our company and what it means to the growth of our company.
I have tried to include many different examples from a range of different industries so you can get the idea of how this will work for you.
As with everything I try to teach, please let me know if you have any questions or if there is anything I can make clearer for you.
Thanks as always for reading and I hope you found some value in this post.