What You Will Learn
- What the “change” REALLY means in change in working capital
- The difference between “working capital” and “change in working capital”
- How to calculate changes in working capital properly with examples
- How it is used in the owner earnings calculation with examples
When a better tool (idea or approach) comes along, what could be better than to swap it for your old, less useful tool? Warren and I routinely do this, but most people, as Galbraith says, forever cling to their old, less useful tools. – Charlie Munger
Today is the day the dust on the topic of changes in working capital finally settles.
Incredible Tax Breaks: How Economic Opportunity Zones Work (Special Report)
This is the first part of a multi-part series on Economic Opportunity Zones. The tax-efficient zones were brought in as part of the Tax Cuts and Jobs Act of 2017 to try and stimulate economic activity in underdeveloped regions. Q2 2020 hedge fund letters, conferences and more The following articles will cover the benefits Read More
Read this page slowly, and download the worksheet to take with you because the whole topic of changes in working capital is very confusing. Spreadsheet includes examples, calculations and the full article.
It’s taken a lot of thought over many years to fully understand this idea of what the “change” in changes in working capital actually means and how it should be applied to valuation and financial analysis.
Here’s another quote from Munger before I dive into things as it sums up this topic well.
Getting Back to the Basics of “Change” in Working Capital
First, working capital is NOT the same as the change in working capital.
If you just want the definition of working capital, it’s simply
current assets – current liabilities.
But what you really need to know about working capital is how and why it matters. That’s where the “change” comes into play.
Previously, I concluded that it was all about the difference from the current year and the previous year.
From an accounting standpoint and definition, that’s correct and what the following articles and explanations are referring to.
- How changes in working capital affect cash flows
- Changes in working capital
- Working capital definition
But a different view is needed for investors when analyzing and valuing stocks.
Instead of an equation just telling you what working capital is, the real key is to understand what the change part really means, how to interpret and use it when analyzing and valuing companies.
Difference Between “Working Capital” and “Change in Working Capital”
Let’s start with the definition of working capital again.
Working Capital = Current Assets – Current Liabilities
Working capital is a balance sheet definition which only gives you insight into the number at that specific point in time.
However, the real purpose any business needs working capital is to continue operating the business.
That’s the REAL purpose of working capital.
Not to see whether there are more current assets than current liabilities. If you are a business owner, it makes no sense to constantly check whether you have more assets than liabilities on the balance sheet.
Operating Working Capital or Non Cash Working Capital
One line that I like from the Wikipedia definition is this:
companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretching accounts payable.
Note the emphasis on the word cycle. It’s not talking about a value from a single point in time. It’s referring to the entire cycle that businesses constantly try to shorten.
What this also means is that when talking about working capital needs, you need to break it down to consider the operating aspects only.
Just like how capital expenditures can be broken down between growth capex and maintenance capex, working capital has to be broken down to “operating working capital”.
Another name for this is non cash working capital, because current assets includes cash, which is not used to operate the business and has to be taken out.
To save time and for simplicity sake as I write this, I’m going to take the numbers from the Cash Flow Statement of the Old School Value Analyzer.
This is how the change in cash flow section is broken down.
The operating parts of the asset side of working capital include;
- Accounts receivables
- Prepaid expenses
- and some uncommon current assets found in the financials
Increasing any of these requires the use of cash.
Current liabilities also include debt which is not an operating factor of the business.
The ones that are categorized as operations on the liabilities side are;
- Accounts payable & accrued expenses
- Deferred revenue
- Income taxes payable
- and some uncommon current liabilities found in the financials
Increasing any of these requires delaying the use of cash.
And that’s what the Wikipedia line is also pointing to.
companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretching accounts payable.
What the CHANGE Really Stands For
This is the difficult and confusing part so read and chew on it slowly so that you can digest it fully.
Ultimately, the change does not mean the difference. That’s the problem I fell into.
You should not just grab these items from the balance sheet and calculate the difference.
Here’s the wrong way of doing this because it’s so easy to get things mixed up and get an incorrect number.
- calculate the working capital in year 1 from the balance sheet
- calculate the working capital in year 2 from the balance sheet
- subtract to get the “change”
But there is a formula which I’ve provided in the next section.
Change in Working Capital is a cash flow item and it is always better and easier to use the numbers from the cash flow statement as I showed above in the screenshot.
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 is increasing, cash is being used.
If current liabilities part is 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 is 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.
If Changes in Working Capital is positive, the change in current operating liabilities has increased more than the current assets part.
Put another way, if changes in working capital is negative, the company needs more capital to grow, and therefore working capital (not the “change”) is actually increasing.
If 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.
These two last sentences is also the key to calculating owner earnings properly which I get to further below.
The Calculation of Changes in Working Capital
Earlier, I said it’s not a good idea to grab the numbers from the balance sheet to calculate this.
But if you’re looking at a company where you can’t find the numbers from the cash flow statement for whatever reason, here’s how you do it and how the data from the OSV Analyzer is provided.
Changes in Working Capital
= Previous Working Capital – New Working Capital
= (Previous Current Assets – Previous Current Liabilities)
– (New Current Assets – New Current Liabilities)
= (Previous Current Assets – New Current Assets)
+ (New Current Liabilities – Previous Current Liabilities)
Change in Working Capital Examples
Let’s compare the changes in working capital between Microsoft and Apple, and then Wal-Mart and Amazon.
Without showing you the numbers first, my initial guess is that because Microsoft is mainly a software business, their change in working capital should be positive. i.e. MSFT can grow with less capital.
Apple being more focused on the hardware side than Microsoft should show a negative change in working capital. Or even if it is positive, should require more capital than Microsoft to grow.
I’m surprised with the change in working capital for Microsoft, as it fluctuates regularly.
If you go through the items, the takeaway here is that Microsoft is collecting more from its AR balance and increasing inventory. In 2015, Microsoft used more muscle to extend payments to reduce the capital needed to grow. The TTM number is lower than 2015 due to an increase in inventory and lower account payables (being a good customer).
While there aren’t any red flags or signs of constant working capital needs by Microsoft, it’s not as good as I initially thought it would be.
Compare this with Apple.
A totally different story where change in working capital is consistently positive. Current operating liabilities has increased more than the operating assets each year.
Positive change in working capital means that the company needs less capital to grow.
Based on just change in working capital alone, Apple is the better and more efficient business.
Another comparison to study is Wal-Mart vs Amazon.com.
Surprising again because Wal-Mart is spending less on inventory since 2014.
For such a capex heavy business, they’ve now worked to improve the way working capital is being used. Previously, Wal-Mart kept having to pay for inventory faster than it was paying its bills.
It needed a lot more cash to keep growing. However, the big shift in 2015 is due to the huge leap in accounts payable resulting in positive change in working capital.
i.e. they are delaying payments to vendors and suppliers to improve their cash flow.
Amazon on the other hand does things very differently.
Over the past few years, Amazon is spending even more on inventory than Wal-Mart. Their accounts payables is consistent, but the deferred revenue is the awesome part. The rate at which they are collecting cash upfront before an item or service is provided is growing exponentially.
This is such a difference to the Wal-Mart model where money in equals item out. As Wal-Mart continues to improve and focus on their e-commerce business, their numbers should shift to look more like Amazon going forward.
Amazon is able to accept the cash first, use it to grow operations, then after a while provide the goods or service to the customer.
Using Change in Working Capital to Calculate Warren Buffett’s Owner Earnings
The whole point of understanding changes in working capital is to know how to apply it to your cash flow calculation when doing a DCF.
Specifically, how do you use changes in working capital to calculate owner earnings?
Buffett’s brief mention of working capital in his letter when he first brought up the idea of owner earnings honestly made things even more confusing.
If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.) – 1986 Berkshire letter
Here’s how I interpreted it previously.
Buffett also mentions “additional working capital” in the paragraph. He says that additional working capital “should be included in (c)”. This means that on any given year where additional working capital is required to maintain the business, it should be included in capex. Otherwise, the rest of working capital should be excluded from owner earnings.
And this is where I got it wrong.
I was too caught up with whether it should excluded or included and how to calculate it.
If you went through everything in this article up to this point to truly understand what the CHANGE means, Buffett is simply talking about the importance of cash flows due to working capital.
The increment he is referring to is the increase in the current operating assets as mentioned above. Whether the asset or liabilities side has the increment is going to determine whether you include or exclude the change in working capital.
(You’ll get it when I go through more examples further down.)
Wal-Mart has to continually buy more inventory to maintain its competitive position and unit volume.
Again, Buffett isn’t going into the specifics of whether to add or subtract the number. He is saying that you should think about how the cash flow requirements of the business is to affect the final owner earnings calculation.
It’s also a case by case basis.
Here’s the simple version.
- If the change in working capital is negative, that means working capital increased as the company needs more capital to grow. This reduces cash flow and so it should reduce the owner earnings. (excluded in this case)
- If changes in working capital is positive, that means working capital decreased as the company has more cash for the company to grow and play with. This increases cash flow and so it should added to owner earnings. (included in this case)
My problem was that I was looking at the numbers too much without seeing the entire picture of cash flow. This led me to my mistakes in the calculations.
However, when you look and think about each component and simplify it to the two points above, it makes the entire calculation that much easier.
The overall owner earnings formula is still accurate.
Owner Earnings =
(a) Net Income
+ (b) depreciation, amortization
+/- (b) other non cash charges
– (c) annual maintenance capex (or the full capex)
+/- changes in working capital
If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.) – Buffett
Microsoft Owner Earnings Example
Numbers and formatting is from Old School Value, follow along if you a member. You can get these numbers from the SEC filings too and follow the examples.
Using the TTM figures in millions:
- Net income = $12,273
- D&A = $5,990
- Other non cash charges = $2,598
- Capex = $6,018
- Changes in working capital = ($1,471)
Because changes in working capital is negative, it should reduce FCF because it means working capital has increased and decreases cash flow.
Therefore, Microsoft’s TTM owner earnings comes out to be:
12,273+5,990+2,598-6,018 – 1,471 = 13,372
Although the change in working capital is negative, you don’t subtract it to do a double negative.
In math form, all I did was
12,273+5,990+2,598-6,018 + -1,471 = 13,372
i.e. don’t do – -1,471 because it comes back to my error of focusing too much on the numbers and signs.
That’s why the formula is written as +/- changes in working capital.
The goal is to
- calculate the change in working capital
- determine whether the cash flow will increase or decrease based on the needs of the business
- add or subtract the amount
Amazon Owner Earnings Example
I’m going to show 5 years of results for Amazon to show the hidden strength of what changes in working capital can reveal when used with owner earnings.
Unlike Microsoft or Wal-Mart, Amazon changes in working capital is positive. It is added to the owner earnings as the company needs less capital to grow and so it will increase cash flow.
Using the TTM figures in millions:
- Net income = $328
- D&A = $5,909
- Other non cash charges = $2,001
- Capex = $4,424
- Changes in working capital = $6,422
- Owner Earnings = 328 + 5909 + 2001 – 4424 + 6422 = 10,236
And because of the strength in their business model, the owner earnings greatly outpaces the standard FCF calculation.
For most companies you analyze, by using the change in working capital in this way, the FCF calculation and owner earnings calculation is similar.
Only when there are big differences in changes in working capital will you see a divergence between FCF and owner earnings.
Rules of Thumb and Summary
The fundamental purpose of even discussing working capital is about cash flow needs of a business. Not the balance sheet calculation.
If an asset increases:
- change in working capital is negative
- actual working capital increases
- cash flow is reduced
- subtract the change from cash flows for owner earnings
i.e. Asset increase = spending cash = reducing cash = negative change in working capital
If liability increases:
- change in working capital is positive
- actual working capital decreases
- cash flow is increased
- add the change to cash flow for owner earnings
i.e. Liability increase = owing something = not spending cash upfront = increase in cash = positive change in working capital
- FCF calculation example using changes in working capital
- youtube video
- DCF calculation with change in working capital explanation
- Prof Damodaran on non cash working capital
Article by Jae Jun. Oldschool Value