Change in Working Capital: Calculations and Meaning (19:40)

In this tutorial, you’ll learn what the Change in Working Capital means, how to calculate it, and why it matters more than Working Capital itself in valuation and DCF analysis.

Tutorial Summary & Description

In this tutorial, you’ll learn what the Change in Working Capital means, how to calculate it, and why it matters more than Working Capital itself in valuation and DCF analysis.

Why Does Working Capital Matter?

Many sources define “Working Capital” as Current Assets minus Current Liabilities.

That is technically true, but it misses important elements: why it matters, and how you use it in a valuation or DCF analysis.

For valuation and financial modeling purposes, it’s really the Change in Working Capital that matters and impacts a company’s intrinsic value.

Working Capital, by itself, could mean many different things.

For example, if a company’s Working Capital is negative, that’s not necessarily a “negative sign” because it depends on the reason it’s negative.

If it’s negative because the company has minimal Inventory and Receivables (Assets) and a high Deferred Revenue balance (Liability), for example, that’s actually a positive sign for a company that collects substantial cash upfront.

But if it’s negative because the company has an extremely high Accounts Payable balance and very little in Operational Assets, that’s a negative sign because it means the company may have trouble paying for its upcoming bills.

Working Capital and the Change in Working Capital: How to Calculate Them

Let’s look at a simple example based on Wal-Mart’s financial statements.

The official definition would tell you to calculate Working Capital like this:

Working Capital Calculation

However, this is misleading because items such as Cash and Debt should not be a part of Working Capital – at least not in the way we use the figure in valuations and financial analysis.

Cash and Debt are considered financial items, not operational ones, and Working Capital should be entirely operational. The same applies to Capital Leases, which are also a form of Debt.

It’s better to count only operational Assets and operational Liabilities in the definition:

Operating Working Capital Calculation

Some people call this “Operating Working Capital,” but we tend to simplify and just refer to it as “Working Capital.”

So, Working Capital here would be:

  • Year 1 Working Capital: $6,768 + $43,803 + $1,588 – $38,080 – $18,808 – $2,211 = ($6,940)
  • Year 2 Working Capital: $5,937 + $40,714 + $1,744 – $36,608 – $18,180 – $1,164 = ($7,557)

To calculate the Change in Working Capital, as it is shown on the financial statements in a DCF analysis, you use:

  • Change in Working Capital = Year 1 Working Capital – Year 2 Working Capital

Here, that would mean: ($6,940) – ($7,557) = $617

Yes, that’s right: you subtract the more recent Working Capital figure to calculate this number.

Why?

Because when Working Capital increases, that reduces a company’s cash flow, and when Working Capital decreases, that reduces a company’s cash flow.

To understand why, imagine that Working Capital consists of only one item: Inventory, an Asset.

The company has no other Operational Assets and no Operational Liabilities.

What happens if Inventory increases by $100?

It means the company spent $100 of its cash flow to purchase more Inventory!

Therefore, this $100 increase in Working Capital reduces the company’s cash flow by $100, and it’s shown with a negative sign on the Cash Flow Statement.

If Inventory decreases by $100, then it means the company has sold that Inventory, which increases its cash flow by $100.

Therefore, this $100 decrease in Working Capital increases the company’s cash flow by $100, and it’s shown with a positive sign on the Cash Flow Statement.

If you want more realistic scenarios, think about the individual items that are typically included in Working Capital:

  • Most Common Current, Operating Assets: Accounts Receivable, Inventory, and Prepaid Expenses.

With all these items, the company has paid for them upfront in cash, or they represent cash payments the company is waiting on. Increasing these items will cost the company cash!

  • Most Common Current, Operating Liabilities: Deferred Revenue, Accounts Payable, and Accrued Expenses.

With all these items, the company “gets” cash. When they increase, the company’s cash flow goes up because it’s getting cash in advance (Deferred Revenue) or because it’s delaying payments (AP and AE).

So, the Change in Working Capital tells you which group of items increases by a greater amount:

  • Current Assets Excluding Cash?
  • or Current Liabilities Excluding Debt?

If this Change is NEGATIVE, then Current Assets are increasing by MORE than Current Liabilities!

Interpretation: Company might be spending a lot on Inventory, it might be waiting too long for customer payments, or it might be paying suppliers very quickly…

If this Change is POSITIVE, then Current Liabilities are increasing by MORE than Current Assets!

Interpretation: The company could be collecting a lot of cash upfront, it might have no or minimal inventory, or it might just be delaying payments to suppliers.

How to Calculate Change in Working Capital from Balance Sheet – And Why It’s a Bad Idea

One thing you’ll quickly notice as you start analyzing companies’ financial statements is that the Change in Working Capital, as directly calculated on the Balance Sheet, rarely, if ever, matches the numbers on the Cash Flow Statement.

For example, for Wal-Mart, the calculation is what we laid out in the screenshot above:

  • Year 1 Working Capital: $6,768 + $43,803 + $1,588 – $38,080 – $18,808 – $2,211 = ($6,940)
  • Year 2 Working Capital: $5,937 + $40,714 + $1,744 – $36,608 – $18,180 – $1,164 = ($7,557)
  • Change in Working Capital = Year 1 Working Capital – Year 2 Working Capital
  • Change in Working Capital = ($6,940) – ($7,557) = $617

But… take a look at Wal-Mart’s Cash Flow Statement:

Change in Working Capital Calculation

So, why it different?

The short answer is that companies often classify and categorize items slightly differently on Balance Sheet and Cash Flow Statement, so the Change in Working Capital numbers will rarely, if ever, match up.

Therefore, while you can potentially use the Balance Sheet to calculate the Change in Working Capital, it is much better to use the numbers directly stated on the company’s Cash Flow Statement in the Cash Flow from Operations section.

We follow that same approach in this example, and in all our financial modeling courses.

Examples and Real World Interpretations of the Change in Working Capital

Example #1: Wal-Mart

Change in Working Capital Calculation - Wal-Mart

Wal-Mart’s Change in Working Capital is always negative due to huge Inventory expenditures – since Wal-Mart is an offline retailer, it must pay for Inventory before selling it.

It does keep suppliers waiting a fair amount since its AP balance is also high and increasing each year, but Inventory spending outweighs that.

This means that as Wal-Mart’s business grows, it requires ADDITIONAL cash to keep growing!

But as a % of revenue, this is very small, so it makes a minimal impact. It will reduce the company’s valuation in a DCF, though, because this will push down Free Cash Flow.

Example #2: Amazon

Change in Working Capital: Calculations and Meaning (19:40)

Amazon’s Change in Working Capital, by contrast, is positive each year.

It’s still spending a lot on inventory… and as a % of revenue, the change is higher than Wal-Mart’s each year…

But it is also not paying suppliers as quickly and is accruing more to its Accounts Payable balance each year.

For Wal-Mart, the increase in Inventory exceeds the increase in AP every year… for Amazon it’s the opposite! Plus, the Deferred Revenue from customers paying in cash in advance for products boosts Amazon’s cash flow.

The end result: for Amazon, the Change in Working Capital boosts its Free Cash Flow and, therefore, its valuation in a DCF – quite significantly since it exceeds Net Income.

Example #3: Salesforce

Change in Working Capital Calculation - Salesforce

Salesforce also has a positive Change in Working Capital…

No inventory is required since it’s a subscription software company!

But it still has AR and Deferred Commissions, which must be paid upfront to sales reps in cash and then recognized over the term of the customer’s subscription.

The Net Change in Working Capital still ends up being positive, though, thanks to that huge increase in Deferred Revenue each year… subscriptions are often sold months or years in advance, but the cash is collected upfront.

So as Salesforce grows, it doesn’t require additional cash – it GENERATES additional cash. This will increase its Free Cash Flow and, therefore, increase its valuation in a DCF.

Summary: What Does the Change in Working Capital Mean?

The Change in Working Capital answers a simple, but very important, question when you analyze a company:

As the business grows, does it generate MORE cash than you expect… or it does it REQUIRE additional cash to grow?

It makes a big difference in a DCF analysis when you value a company based on its future cash flows, but it also makes a difference in financial statement analysis, debt vs. equity analysis, and other financial modeling work.