The Change in Working Capital in Valuation and Financial Modeling (29:15)

In this tutorial, you’ll learn about Working Capital and the Change in Working Capital in valuations and financial models – what they mean, how to project these items, and how to check your work.

Change in Working Capital Summary: On the Cash Flow Statement, the Change in Working Capital is defined as Old Working Capital – New Working Capital, where Working Capital = Current Operational Assets – Current Operational Liabilities.

It’s defined this way on the Cash Flow Statement because Working Capital is a Net Asset, and when an Asset increases, the company must spend cash to do so. For example, think about Inventory: if it goes up, and no other items change, the company must have spent some of its cash to purchase this Inventory.

Therefore, if Working Capital increases, the company’s cash flow decreases, and if Working Capital decreases, the company’s cash flow increases.

That explains why the Change in Working Capital has a negative sign when Working Capital increases, while it has a positive sign when Working Capital decreases.

The Change in Working Capital gives you an idea of how much a company’s cash flow will differ from its Net Income (i.e., after-tax profits), and companies with more power to collect cash quickly from customers and delay payments to suppliers tend to have more positive Change in Working Capital figures.

In 3-statement models and other financial models, you often project the Change in Working Capital based on a percentage of Revenue or the Change in Revenue.

The Change in Working Capital – Video Table of Contents:

  • 2:45: Part 1: Why We Care About the Change in Working Capital
  • 4:33: Part 2: What is “Working Capital”?
  • 9:56: Part 3: The Change in Working Capital
  • 14:47: Part 4: Working Capital for Best Buy and Zendesk
  • 18:23: Part 5: Is Item X a Part of Working Capital?
  • 21:40: Part 6: Wait, Why Don’t the Cash Flow Statement and Balance Sheet Figures Match?!!
  • 26:01: Recap and Summary

Here’s the video in text form if you prefer to read rather than watch:

Part 1: Why Does the Change In Working Capital Matter?

We care about the Change in Working Capital because a company’s implied value depends on its future cash flows:

Company Value

But you can’t just look at a company’s Income Statement to determine its Cash Flow because the Income Statement is based on accrual accounting.

Therefore, there might be significant differences between the “after-tax profits” a company records and the cash flow it generates from its business.

So, Cash Flow is quite different from Net Income, and a big component of Cash Flow is the Change in Working Capital.

The Change in Working Capital could be positive or negative, and it will increase or reduce the company’s Cash Flow (and Unlevered Free Cash Flow, Free Cash Flow, and so on) depending on its sign.

Here’s an example for Target:

Cash Flow from Operations

The Change in Working Capital could positively or negatively affect a company’s valuation, depending on the company’s business model and market.

The Change in Working Capital tells you if the company’s Cash Flow is likely to be greater than or less than the company’s Net Income, and how much of a difference there will be.

In most cases, it will follow a very obvious pattern or no pattern at all – which means that forecasting it in financial models should never be that complicated.

Part 2: What is “Working Capital”?

Traditionally, Working Capital is defined as Current Assets minus Current Liabilities:

Working Capital - Traditional Definition

…but that’s not how companies calculate it in their financial statements.

A better definition is Current Operational Assets minus Current Operational Liabilities, which means you exclude items like Cash, Debt, and Financial Investments.

Sometimes, companies also include longer-term operational items, such as Deferred Revenue, in their Working Capital.

The best rule of thumb is to follow what the company does in its financial statements rather than trying to come up with your own definitions.

Here’s our improved definition of Working Capital:

Operating Working Capital

The meaning of a positive or negative Working Capital depends on why it is positive or negative. For example, consider these two companies:

Company A:

  • Accounts Receivable = $100
  • Inventory = $100
  • Deferred Revenue = $500

Company B:

  • Accounts Receivable = $100
  • Inventory = $100
  • Accounts Payable = $500

Company A’s Working Capital is $100 + $100 – $500 = ($300), and Company B’s Working Capital is also $100 + $100 – $500 = ($300).

But Company A is in a stronger position because Deferred Revenue represents cash that it has collected for products and services that it has not yet delivered.

The $500 in Accounts Payable for Company B means that the company owes additional cash payments of $500 in the future, which is worse than collecting $500 upfront for future products/services.

So, the sign matters less than the explanation.

Part 3: The Change in Working Capital

The Change in Working Capital, as shown on the Cash Flow Statement, equals Old Working Capital – New Working Capital.

Yes, this is the opposite of what sites like Investopedia and Wikipedia say… and they’re wrong (or at least, misleading).


Because Working Capital is a Net Asset on the Balance Sheet, and when an Asset increases, that reduces cash flow; when an Asset decreases, that increases cash flow.

For example, imagine that a company’s Working Capital consists of a single line item: Inventory.

If the company’s Inventory increases from $200 to $300, it needs to spend $100 of cash to buy that additional Inventory.

Therefore, the Change in Working Capital = $200 – $300 = ($100), so it’s negative, and it reduces the company’s cash flow:

Change in Working Capital - Signs

When the company finally sells and delivers these products to customers, Inventory will go back to $200, and the Change in Working Capital will return to $0.

The company’s cash flow will increase not because of Working Capital, but because the company earns profits on the sale of these products.

For example, maybe the company sold these products for $150 after purchasing the parts and supplies (i.e., Inventory) for $150.

If that’s the case, the company’s cash flow increases by ($150 – $100) * (1 – Tax Rate) from beginning to end.

If the Change in Working Capital is negative, the company must spend in advance of its revenue growth – like a retailer ordering Inventory before it can sell and deliver its products.

If the Change in Working Capital is positive, the company generates extra cash as a result of its growth – like a subscription software company collecting cash for a year-long subscription on day 1.

The Change in Working Capital, therefore, reflects the company’s business model, including when it collects cash from customers, when it pays suppliers, and when it pays for Inventory relative to delivery of the product or service.

Part 4: Working Capital for Best Buy and Zendesk

To illustrate these concepts in real life, let’s take a look at the Change in Working Capital for two companies: a retailer (Best Buy) and a subscription software company (Zendesk).

Here are the numbers:

Best Buy and Zendesk Comparison

The key questions here include:

  1. How significant is the Change in Working Capital for each company?
  2. Does it increase or reduce each company’s Cash Flow?
  3. Why is the Change in WC positive or negative?
  4. How would you project the Change in WC for these companies? Are there consistent trends?

To answer these questions, you can look at the Change in Working Capital as a percentage of Revenue and the Change in Revenue.

For both companies, the Change in WC is a fairly low percentage of Revenue, which tells us that it’s not that significant in either case. It is a bit higher for Zendesk, so it’s slightly more important there.

The Change in WC has a mixed/neutral effect on Best Buy, reducing its Cash Flow in some years and increasing it in others, while it always increases Zendesk’s Cash Flow.

That is consistent with our expectations for a subscription software company: due to the ever-increasing Deferred Revenue, the Change in WC is positive in each period.

It looks like Best Buy’s Change in WC does not follow an obvious pattern, so we would probably make it a simple, low percentage of the Change in Revenue in a projection model.

The Change in WC / Change in Revenue is more significant for Zendesk, so we would probably average the 11.0%, 14.6%, and 2.5% numbers here and use that average figure in the projections.

We might also use a slightly higher number if these percentages were higher in historical periods further back.

Part 5: Is Item X a Part of Working Capital?

We receive many questions about whether various items, such as Deferred Taxes, Income Taxes Payable, and Operating Lease Assets and Liabilities should be part of Working Capital.

The short answer is that you should follow what the company does, and you shouldn’t worry about placement as long as the item correctly factors into Cash Flow from Operations (and metrics like Free Cash Flow and Unlevered Free Cash Flow).

For example, suppose that your friend sees that Target has included “Other Current Assets” in its Working Capital.

Your friend argues this is wrong and that changes in Other Current Assets should not be part of the Change in Working Capital.

He looks at your spreadsheet and presents this revised version to you:

Change in Working Capital Classifications

The appropriate response here is “Who cares?”

Regardless of where you put this item, the company’s Cash Flow from Operations stays the same!

The same principle applies to items like Operating Lease Assets and Liabilities under U.S. GAAP, Income Taxes Payable, and so on.

It doesn’t matter where they go as long as they affect Cash Flow from Operations correctly.

Just make sure that changes in Cash, Debt, and Financial Investments are NOT in Cash Flow from Operations or the Change in Working Capital.

So, if the company somehow classifies these items within Working Capital, remove and re-classify them; they should never affect Cash Flow from Operations.

Part 6: Wait, Why Don’t the Cash Flow Statement and Balance Sheet Figures Match?!!

Finally, the Change in Working as calculated manually on the Balance Sheet will rarely, if ever, match the figure reported by the company on its Cash Flow Statement.

Here’s an example for Target:

Target - Manual Change in Working Capital

Change in Inventory = $9,497 – $8,992 = $505

Change in Other Current Assets = $1,466 – $1,333 = $133

But if you look at their numbers on the Cash Flow Statement under the “Changes in Operating Accounts,” you’ll see:

Target - Change in WC on Cash Flow Statement

So, the Change in Inventory matches, but the Change in Other Assets does not – even if you adjust it by including the change in Other Noncurrent Assets as well.

These types of mismatches will always occur, so you should ignore them and focus on the projections.

They happen mostly because companies group items differently on the statements, so there isn’t necessarily a 1:1 match between a specific item on the Balance Sheet and the “Change” line for that item on the Cash Flow Statement.

Also, changes in accounting policies, acquisitions, and divestitures can distort the numbers.

Focus on the overall Change in Working Capital relative to Revenue and the Change in Revenue and make sure it’s sensible going forward.

There is no way to resolve these discrepancies unless you have access to the company’s internal financial reports, and you will drive yourself crazy and end up jumping into a pit of lava filled with lava-resistant crocodiles if you try to “fix” them.

About Brian DeChesare

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.