Working Capital is a key metric in valuation and financial modelling. Knowing the term is important since not only does it help in your study and work, but you might get questions related to it in interviews if you want to break into lucrative finance careers including Investment Banking, Private Equity and Hedge Fund.
First of all, Working Capital/ Net Working Capital is not quite a complex metric. However, you have to know what it represents, how it is used in valuation and financial modelling, or free cash flow in specific. There are a lot of controversies around the formula to calculate it. Yet when it comes down to it, substance is always over form. Understanding the nature of a metric is much more important than just knowing how it is calculated. Although there might be several formulas getting to different results of working capital, the most important part is to understand the metric.
1. Net Working Capital
Working Capital is calculated as a difference between Current Assets and Current Liabilities.
These are two approaches to arrive at a value of working capitals:
NET WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES
- Current Assets represent the total value of current assets, which can be taken from the Balance Sheet
- Current Liabilities are the total value of current liabilities presented in a firm’s balance sheet.
However, analysts and investors sometimes exclude cash and debt from the current assets and current liabilities to calculate the Net Working Capital, that’s why we have another formula:
NET WORKING CAPITAL = CURRENT ASSETS (cash and cash equivalent exclusive) – CURRENT LIABILITIES (debts exclusive)
or it can be rewritten in another way with SIMPLE items on the balance sheet as follows:
NET WORKING CAPITAL = ACCOUNTS RECEIVABLE + INVENTORY – ACCOUNTS PAYABLE
Of course, the formula above just presents simple items in the financial statement. In fact, a firm’s balance sheet contains various other items in current assets and current liabilities.
To understand more as to how to calculate the net working capital, we take the Amazon’s balance sheet as an example. (Unit: All numbers in thousands)
Source: Amazon’s Financial Statements, Yahoo Finance.
Take the figures from Amazon’s balance sheet, we have:
|Current assets (cash inclusive)||96,334,000||75,101,000|
|Current liabilities (debt inclusive)||87,812,000||68,391,000|
|Net Working Capital||8,522,000||6,710,000|
In this case, we couldn’t calculate the working capital with current assets (cash and cash equivalent exclusive) and current liabilities (short-term debt exclusive) because the Amazon’s balance sheet didn’t present the value of short-term debts. It is somewhere in the accrued liabilities. Yet keep in mind that, the net working capital calculated without cash and debt involved are much preferred by analysts and investors nowadays.
2. What is Net Working Capital used for ?
Working Capital measures a firm’s ability to meet short-term liabilities, or short-term obligations. If the difference poses a positive value, it means the firm is likely to fulfill the short-term obligations. If the result is negative, the firm is in a precarious position. Hence, the favorable situation for a firm is to have the value of current assets in excess of that of current liabilities, leading to the positive net working capital.
Net Working Capital is used to calculate the change in net working capital between two different periods, that explains its importance. And Change in Net Working Capital is an integral part to arrive at the value of Free Cash Flow, which is used in valuation and financial modelling.
3. In-depth Explanation of Working Capital
As mentioned above and you might know, Net Working Capital enables analysts and investors to gauge where a company is positioning. However, a negative net working capital does not always mean the company is not looking great.
You have to look at the long-term usage of resources of the firm. That said in the paragraph above, when a company has more current assets than its current liabilities, it can easily settle the short-term debts. Nonetheless, a positive working capital could possibly imply the inefficient use of its existing resources. Analysts and investors could make an assumption that the company is not investing to expand its operation.
Similarly, a negative working capital does not always present a bad situation. In this case, analysts have to deep dive to see if the company is deploying its resources for improving the firm’s operation or expansion.
However, a long-term less-than-zero working capital is likely to lead the company to a bad position because it seems to be unable to pay off their debts.
Now go further into details, the firm’s performance sometimes just doesn’t rely too much on either a negative or positive value. You need to dive deeper into the nature of why it is positive or negative. The paragraph above is an example, here’s an another one:
|Firm A||Firm B|
Short-term accounts receivable: $2,000
Short-term accounts payable: $1,000
Deferred revenues: $3,000
Short-term accounts receivable: $2,000
Short-term accounts payable: $4,000
To arrive at Net Working Capital, we exclude cash and cash equivalent in current assets and debt in current liabilities.
Both firm A and firm B have the same Net working capital of ($1000) which is derived by the calculations (Firm A: $2,000 + $1,000 – $1,000 – $3,000 = ($1,000), Firm B: $2,000 + $1,000 – $4,000 = ($1,000))
- Which firm is in a vulnerable situation?
Albeit the same value of net working capital, firm A’s financial health is stronger than that of firm B.
Firm B owes $4,000 to their suppliers, It will have to pay that amount of money in future. Yet get back to the firm A, despite the same current liabilities, they have the deferred revenues of $3,000. Tt just has $1,000 as a payable, while it has collected $3,000 upfront for the undelivered services/products.
4. What is the Change in Working Capital ?
The Change in Working Capital is defined as a difference between the two different-period net working capitals.
Change in Net Working Capital Formula:
CHANGE IN NET WORKING CAPITAL = NET WORKING CAPITAL FOR CURRENT PERIOD – NET WORKING CAPITAL FOR PREVIOUS PERIOD
Take a look at the table above again, we can calculate the Change in Net Working Capital of the firm:
Change in Net Working Capital from 2018 to 2019 = 8,522,000 – 6,710,000 = 1,812,000
5. Change in Net Working Capital Analysis
- So, what does this figure say?
Both Net Working Capital and Change in Net Working Capital are not only numbers. That’s why you have to understand what these numbers means, and how they support financial analysis. Just learning by heart the formula could possibly lead to the misunderstanding of the concept.
You have already known that positive net working capital implies a firm’s strong position in most of the cases. So how about positive Change in Net working capital?
Change in Net working capital allows analysts and investors to determine the cash flow of a firm. It is a key component to identify free cash flow (both unlevered free cash flow and levered free cash flow).
There’s a little bit complexity here, but first, you need to know:
- A positive Change in Net Working Capital can be seen as cash outflow.
- A negative Change in Net Working Capital basically shows cash inflow.
Here comes an explanation:
- If the change in net working capital presents a positive value, it means the assets of a firm is in excess of current liabilities. This can be seen as that the firm made purchases to increase current assets in the current period, leading to the outflow of cash.
- By contrast, if the change in net working capital is negative, it means the current liabilities show an increase. The firm hasn’t paid money yet, bringing about the inflow of cash.
- Then, what causes the Change in Net Working Capital ?
Since it is a component for Free Cash Flow formula, Change in Net Working Capital can affect a firm’s value.
Listed below is factors that can impact the Change in Net Working Capital:
- If a firm doesn’t allow outstanding credit, the account receivables will decrease. The decrease leads to a decline in current assets, making Change in Net Working Capital drop consequently.
- If the firm has a policy to make payments to their suppliers instantly for every purchase it makes, it means a decrease in current liabilities, resulting in an increase in Change in Net Working Capital.
- If a firm plans to expand its operations and tend to purchase more assets, the current assets will increase (cash exclusive in this case, if the company uses its cash to buy assets, the net change in current assets is zero). This brings out the increase in Change in Net Working Capital.
It is tricky to jump to a conclusion of a firm’s performance by just looking at the negative or positive value of Change in Net Working Capital. Only a figure barely shows the entire thing. As an analyst, he/she will grasp the deep-inside reason why the value is positive or negative. Combining both figures and the behind-reasons would give an analyst a clearer picture of a firm.
6. Why Working Capital ? Why Change in Net Working Capital ?
These are reasons why you have to learn and know more as to what Working Capital and Change of Net Working Capital are:
- These metrics enable analysts and investors to gauge a company’s performance, how its cash flow performs. Though the analysis doesn’t show the big picture, you can evaluate the firm’s performance to a certain extent.
- These metrics are big components to arrive at the value of all types of free cash flow including Unlevered Free Cash Flow (UCFF)/ Free Cash Flow to the Firm (FCFF) and Levered Free Cash Flow (LFCF), which are also called Valuation and Financial Modellings.
- You can expect to be asked questions related to these metrics in an interview from HireVue (the first round) to Superday/ Assessment (the final round). If you stumble on such an easy question, you are much likely to be out of the race.
Net Working Capital and Change in Net Working Capital are easy metrics that require you to learn by heart and grasp the meanings behind these metrics. Besides, you can refer to technical articles published on our website to have a better picture of what Investment Banking recruiters tend to ask and the range of technical knowledge an interview can cover in an interview.