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Non-Cash Working Capital: A Critical Component of Valuation and FCF

Working capital is one of the engines that drives a business to profitability and growth. It is the combination of current assets and current liabilities that the company uses for short-term needs. But the combination includes cash items such as short-term cash, which is not working capital.

Working capital is a critical component of valuation, and determining the drivers of the value of a company is understanding those drivers.

My investment teacher, Aswath Damodaran, presents a different way to look at working capital, which I think best captures the value drivers of working capital and gives us a truer valuation. Many of these ideas echo in the writings of the great Michael Mauboussin, another valuation guru, in his great book, Expectations Investing.

In today’s post, we will learn:

  • What is Non-Cash Working Capital?
  • Working Capital Vs. Non-Cash Working Capital
  • How to Estimate Changes in Non-Cash Working Capital
  • Investor Takeaway

Okay, let’s dive in and learn more about non-cash working capital.

What is Non-Cash Working Capital?

Before defining non-cash working capital, let’s take a quick look at the classic definition of working capital. The classic definition of working capital is the difference between current assets and current liabilities. Many of the items in working capital such as accounts receivables (unpaid bills from customers), inventories of finished goods or raw materials, and accounts payables.

The easiest way to think of working capital is it is the money Microsoft uses to cover its short-term expenses, such as buying inventories used within the calendar year.

Much of the working capital pays for inventory needs, short-term debt, and other day-to-day needs. We can consider these the operating expenses of Microsoft, and we know from our studies on valuation, improving operating margins helps grow the free cash flows. These improvements also filter to the ROIC (return on invested capital) metric, which helps us measure the profitability and reinvest for more growth.

Working capital, also known as net working capital, ebbs and flows from company to company, some companies are more seasonal; think of retail as we approach the holiday shopping season. As that approaches, their needs for working capital will grow.

Okay, now that we understand working capital, let’s look at non-cash working capital.

Per Professor Damodaran, non-cash working capital removes items not used for the operations of the business. He suggests we back out items such as cash and investments in marketable securities. The reason for removing items such as investments is that tying this cash up in treasury bills, short-term investments, or commercial paper means it is not available for daily operations.

These investments make the company money, albeit not much, because of the low yields in today’s low-interest-rate environment. But the bottom line is they do make the company more money than the cash in inventories or accounts receivable.

Think about the cash tied up in inventories; it is a wasting asset, same with accounts receivable. These items make the company no money while that pile of shoes sits in the warehouse, or the unpaid bill goes unpaid. Until you sell the shoes or collect on the bill, does it become revenue.

There are exceptions, of course; if the company carries a large cash balance that it uses for day-to-day operations, we should consider it in the working capital needs.

He also backs out all interest-bearing debt, such as short-term debt and the long-term portion of the debt that is due in the current period. He uses that portion of the debt when calculating the cost of capital, and counting it among working capital is double-dipping.

His definition of non-cash working capital is a little cleaner. He defines working capital as non-cash current assets (inventory and accounts receivable) less the non-cash current liabilities (accounts payable). He excludes any investment that ties up cash.

Any increases (decreases) in non-cash working capital will reduce (increase) cash flows for Microsoft during that period from a valuation aspect or cash flow view.

When we forecast future growth for Microsoft, it is important to forecast the impact of such growth on non-cash working capital needs and build those impacts into Microsoft’s cash flows.

Working Capital Vs. Non-Cash Working Capital

Next, let’s look at the differences between working capital and non-cash working capital for Amazon (AMZN). We will use the latest 10-k report dated February 3, 2021, and all numbers will be in millions unless otherwise stated.

The chart below will break down the components of working capital, focusing on the current assets and liabilities. We will also note the differences between the classic definition of working capital and non-cash working capital. The non-cash working capital items will be in bold to help highlight the differences.

Line Item

2019

2020

Cash and equivalents

$36,092

$42,122

Marketable securities

$18,929

$42,274

Inventories

$20,497

$23,795

Accounts receivable

$20,816

$24,542

Total current assets

$96,334

$132,733

Non-cash current assets

$41,313

$48,337

Accounts payable

$47,183

$72,539

Accrued expenses

$32,439

$44,138

Unearned revenues

$8,190

$9,708

Total current liabilities

$87,812

$126,385

Non-cash current liabilities

$47,183

$72,539

Working Capital

$8,512

$6,348

Non-cash working capital

$(5,870)

$(24,202)

That is super interesting; this tells us that Amazon releases cash back into the cash flows instead of tying it up in non-cash current assets. All of which helps increase the cash flows of the company.

Amazon’s example illustrates how the non-cash working capital affects the company’s cash flows; despite its being a retailer, it doesn’t tie up large amounts of cash in its inventories and waste that cash.

By removing the cash and equivalents from the classic equation, we can see how Amazon manages its working capital. If we look at the current ratio, total current assets divided by current liabilities, we see a ratio of 1.05 for 2020 and 1.09 for 2019. All of which tells us the company carries good liquidity in times of duress, but it doesn’t give us much info about the cash outlay for those items.

Let’s look at another example of non-cash working capital with an Amazon competitor, Walmart. Again, we will take the latest 10-k dated March 19, 2021.

Line item

2021

2020

Cash and equivalents

$17,741

$9,465

Receivables

$6,516

$6,284

Inventories

$44,949

$44,435

Prepaid expenses

$20,861

$1,622

Total current assets

$90,067

$61,806

Non-cash working capital

$72,326

$52,341

Short-term borrowings

$224

$575

Accounts payable

$49,141

$46,973

Accrued liabilities

$37,966

$22,296

Accrued income taxes

$242

$280

Debt due within the year

$3,115

$5,362

Operating leases due within year

$1,466

$1,793

Finance leases due within a year

$491

$511

Total current liabilities

$92,645

$77,790

Non-cash current liabilities

$87,349

$69,549

Working capital

$(2,578)

$(15,984)

Non-cash working capital

$(15,023)

$(7,743)

Again, interesting results and comparable with Amazon’s in that Walmart releases more cash to cash flows than tying it up in inventories or accounts receivable.

How to Estimate Changes in Non-Cash Working Capital

To estimate changes in non-cash working capital is fairly simple for a single year, as we saw from the charts above. But estimating future changes in non-cash working capital is a bit more problematic because the changes from year to year can be extremely volatile.

Some years will have big increases, followed by big decreases. A great practice is to tie the changes in non-cash working capital to revenues for valuation purposes. We can tie the projection of increases or decreases in revenues to the increases or decreases in projected non-cash working capital changes. We can obtain the historical changes in non-cash working capital from the historical financials or use industry averages.

Let’s look at this in a bit more detail, using Intel (INTC) as our guinea pig.

First, we will put together a chart outlining the changes in non-cash working capital concerning revenues.

Line item

2020

2019

Change

Accounts Receivable

7,735

7,352

(383)

Inventory

8,744

8,427

(317)

Other assets

1,637

7,575

5,938

Non-cash current assets

18,116

23,354

5,238

Accounts payable

4,128

5,581

1,453

Accrued Expenses

12,105

12,422

317

Other liabilities

2,384

4,074

1,690

Non-cash current liabilities

18,617

22,077

3,460

Non-cash WC

(501)

1,277

1,778

Revenues

71,965

77,867

5,902

Working Capital % of Revenues

(0.70)%

1.64%

30.12%

Okay, now that we have looked at some historical numbers, we can start to project the non-cash working capital for Intel to work out an intrinsic value for the company.

The first step might be to use the change in non-cash working capital ($1,778) and project that at the same growth rate of earnings growth into the future. However, as we mentioned, changes in non-cash working capital are unpredictable, and last year’s might be an exception.

The same idea applies with the most recent years’ percentage of non-cash working capital to revenues, because the changes are so unpredictable it is far from ideal.

Another choice would be to use the historical averages of non-cash working capital changes compared to revenues, which by annualizing those numbers helps smooth out the ups and downs. The trick would be to do it for a longer period to get a better average. I went ahead and worked that out for Intel over the last seven years, and the number is 0.93%.

The final choice is to use the industry average for the company and ignore the historical rates. This choice works for companies with extreme changes in rates over time or working with microcap companies that start to see growth from scaling up.

Let’s put together a chart outlining how this lines up to help us make the best decision for our valuation.

Current

1

2

3

4

5

Revenues

77,867

81,760

85,848

90,141

94,648

99,380

Changes in revenues

3,893

4,088

4,292

4,507

4,732

Current WC/Revs

1.64%

64

67

70

74

78

Historical Average

0.93%

36

38

40

42

44

Industry Average

17.44%

679

713

749

786

825

The above revenue growth is based on a 5% growth. We can use whichever revenue growth you choose, but you can see a wide range of numbers of non-cash working capital.

The big question then remains, can non-cash working capital be negative? And the answer is obvious, yes. Just look at the charts above for Walmart and Amazon. In the case of both companies, they use their suppliers as a means of managing their cash flows. By this I mean that Walmart, for example, extends their cash flow cycle by extracting longer payback times for the products they buy from their suppliers. And then, Walmart can sell and collect cash for those products before paying for the products, which helps extend Walmart’s cash flows.

Amazon does the same thing, which helps Amazon extend its cash flows by reducing the inventory they need to carry and allowing them to turn over that inventory quicker. Leading to quicker cash flows for Amazon before paying its bills.

The faster the company can turn its inventory, the quicker it can gather the cash and use it for other purposes before paying its bills. It is part of the business model for Amazon and Walmart and helps explain why the companies have negative non-cash working capital. They are using their suppliers as a means of non-cash working capital instead of their own capital.

Let’s look at another company in the same sector to get an idea of how this might work. I choose AMD as our next guinea pig, as they are in the same sector as Intel; it might be interesting to see how the two companies compare.

Below is a chart I put together from a spreadsheet I will share with you to easily calculate all of these numbers.

The chart above outlines the historical non-cash working capital, last year’s non-cash working capital, and industry averages, all compared to AMD’s revenues.

There is also a chart projecting both revenues and non-cash working capital over five years. You could easily adapt the spreadsheet to project them over ten years if you choose.

Investor Takeaway

Working capital impacts the growth of a business; it tells us how much each company spends on its everyday expenses. The classic version includes cash and equivalents, which I think we have shown has little impact on the company’s day-to-day operations; excluding it from the calculations of working capital gives you better insight into the working capital needs of Intel.

The price we pay matters, and calculating the company’s intrinsic value is a complicated process with lots of moving parts. Part of the process is to project the company’s working capital needs because no company can grow without spending money on inventory or accounts receivable.

The spreadsheet I include in the post will help you quickly and easily calculate the numbers to project for a DCF (discounted cash flow) model.

With that, we will wrap up our discussion on non-cash working capital. As always, thank you for taking the time to read this post, and I hope you find something of value in your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave