By Jae Jun. Originally published at ValueWalk.
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.
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
- Inventories
- 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
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