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Jae Jun
Jae Jun
Articles (5983)  | Author's Website |

Changes in Working Capital in Free Cash Flow FCF

November 27, 2009

There are many variations of free cash flow but recently I’ve been asked a couple of times why I don’t include changes in working capital. So let me go through why I don’t believe including changes to working capital is necessary to the free cash flow calculation.But first, a discussion on working capital..

Working Capital and Changes in Working Capital

By definition:
working capital = current assets - current liabilities

Working capital is useful to show the operating liquidity of a company and how the company manages its business.

When we look at the assets of the balance sheet, accounts receivables is listed under assets but when you start thinking about working capital it should actually be under the liabilities section.

The reason why it should be considered as a liability is that the amount of accounts receivables is really just an interest free loan to the customer. The company has not received the cash for the bills. It is only when accounts receivables decreases that cash flow increases. This is what the term “changes in working capital” refers to. The working capital change on the balance sheet impacts the cash flow statement.

For more information, I’ve explained this phenomenon in the analysis of cash flow statements.

Inventory is another major component of working capital and can also be considered to be a liability while accounts payable will add to positive cash flow because it’s money that you owe but haven’t paid yet. So it’s like an interest free loan that increases your cash flow.

Working Capital and Free Cash Flow

So people ask me why I don’t include changes in working capital to the FCF equation in the _stock analysis tools. because clearly accounts receivables does not represent an increase in cash. Inventory also doesn’t bring in cash if it is sitting on the shelf.

Warren Buffett’s FCF: Owner Earnings

The formula I use for FCF is Buffett’s definition of FCF, a.k.a. owner earnings. Do take the time to read the appendix of the 1986 Berkshire letter to shareholders as it explains owner earnings in depth.
Owner earnings = Net income + depreciation & amortization +/- one-time items - capital expenditures

“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

So if changes in working capital is really that important, why doesn’t Buffett use it?

Was it a) because the term never existed in 1986? b) or did he just forget about it?

I believe it is neither.

If you note the bolded section of Buffett’s owner earnings, he clearly states that changes in working capital should also be in (c). That is, if a company is required to increase working capital in order to maintain its position and operations, that’s really an increase of maintenance capex.

Also, since I haven’t found a single person who can accurately judge or calculate maintenance capex, I just use the total capex in the _stock value calculators. which will more than cover the working capital required for maintenance.

Purpose of Free Cash Flow

The way I see it, modern corporate finance has had a lot of influence on the FCF definitions. The part that I feel most people confuse is that by including changes in working capital, it is actually calculating the amount of cash left over for shareholders at the end of the year period.

But as an investor, what exactly are you trying to measure? The amount of money that is available in the business? Or the true profitability?

That’s the key that most investors forget. We use FCF in a discounted cash flow valuation, not to measure how much money is left over for us, but to find the true profitability of the company and the rate of growth at which it can increase those profits.

This is exactly why I believe Buffett calls his modified FCF formula as owner earnings. The true earnings of a company. He publicized the formula to combat the non-effective and rather misleading EBITDA definition of profitability and cash flow.

The Buffett style of investing I’ve read in countless books all mention one thing - he looks for great ongoing businesses with competitive advantages, not how much a company can give out at the end of the year.

Working Capital Disadvantage

Working capital also has it own set of disadvantages.

Current assets and liabilities are fairly easy to manipulate and depending on the accounting method, the amount will vary by considerable amounts. E.g. a company using the LIFO method will have a much lower inventory value compared to a company that uses the FIFO method to value inventory. The two companies could have exactly the same set of products in their warehouses, but just depending on whether they use a conservative or aggressive accounting, it will make a big differences.

Working capital can also vary drastically year to year which could provide an inaccurate picture of the business as well as affect the projected growth rate.

But there is no right or wrong. It just depends on how you view a business and investment.


To sum things up, I simply exclude changes in working capital because my point of view is that I am looking for the true profitability of the company which is why I stick with Buffett’s owner earnings.

Jae Jun

Old School Value.

About the author:

Jae Jun
Jae Jun is the author of Old School Value, a value investing blog dedicated to the Old School methodologies and teachings of the investment greats such as Graham, Buffett and Fisher. The blog deals with finding intrinsic value, fundamental stock analysis and special situations including spinoffs and merger arbitrage.

Visit Jae Jun's Website

Rating: 3.9/5 (16 votes)


Batbeer2 premium member - 7 years ago
Thanks for an interesting article. I agree that leaving out changes in working capital to find earnings power may be meaningfull when taking a long-term approach.

As for capex...... take KTII. A company I believe you know about. IMO it is fair to say maintenance capex for KTII is less than 10m. Here's why:

They spend less than 5m on capex and there is little growth. They spend more than 10m and the effect is that a dollar of capex leads to an extra dollar of revenue without bringing down margins.

So..... should KTII spend more than 10m in a given year, IMO the analyst has reason to adjust the numbers to estimate owner earnings. IMO a reasonable estimate of the maintenance component of capex can be done in some situations. Obviously, such an examination can also be done to see if a company is underspending on capex.




Are examples of companies for which IMO a reasonable estimate of maintenance capex can be made.
Buffetteer17 premium member - 7 years ago
In some cases, working capital, as defined by current assets less current liabilities, is sometimes far more than the cash the company needs to keep on hand to run the business. I give the example of Garmin, which currently, from the 9/2009 10Q, has (all amounts in 1000s of dollars):

Current assets:

Cash and cash equivalents $ 1,011,763

Marketable securities 17,643

Accounts receivable, net 573,847

Inventories, net 373,290

Deferred income taxes 52,824

Prepaid expenses and other current assets 49,569

Total current assets 2,078,936

Current liabilities:

Accounts payable $ 185,668

Salaries and benefits payable 32,787

Accrued warranty costs 83,081

Accrued sales program costs 56,318

Deferred revenue 48,621

Other accrued expenses 141,021

Income taxes payable 14,102

Dividend payable 150,447

Total current liabilities 712,045

So, the working capital is $1,366,891, of which $1,011,763 is cash. Surely, some cash is needed for normal everyday operations, but I find it inconceivable that they require over billion dollars for this purpose. As a matter of fact, some of this money is committed to the upcoming annual dividend payment of approximately $0.75/share, or $150,000, and there is a large share buy back program still running. Even so, that's a heck of a lot of cash.

In my DCF analysis, I figured, with a wave of the hands, that about 3/4 of the cash could be immediately paid out to the owners, which increases the share value (200M shares) by about $3.75. Since the share price is currently around $31, that is an appreciable adjustment.

What has happened is that the company is no longer growing at a furious rate, and they've accordingly cut back on capex, but the cash just piled up faster than they could spend it. If they don't waste it, it is as good as in my pocket.

Disclosure, Garmin is 3% of my portfolio.
Batbeer2 premium member - 7 years ago
>> In some cases, working capital, as defined by current assets less current liabilities, is sometimes far more than the cash the company needs to keep on hand to run the business.

Fair enough. I would argue that you just gave another reason to ignore working capital for calculating owner earnings. Obviously, you can add back excess cash (or other unnecessary assets) to find the intrinsic value. Owner earnings<> Intrinsic value.

In the case of Garmin I would estimate IV as 10x owner earnings + Excess cash.

Mind you, Garmin is on my too hard pile. I can't visualise what they will be doing in ten years... but that is another thread :-)

Robert Sprinkel
Robert Sprinkel - 7 years ago    Report SPAM
This is an excellent discussion rspecially if you are investing in no- or low-yield shares. How else could you possibly determine if a company's owners are making money? (Surely, not from the company's EPS calculation.) So...all good and useful stuff for the typical investor whether you are Mr. Buffett, Mr. Graham, or Mr. Market.

However, some of us, and I am one, have unlocked the door to the high, tax-sheltered distributions available from Master Limited Partnerships (MLPs). Because the goal of the MLP is to pay out as much as prudently possible, EBITDA is a very useful tool and is widely used by MLPs in reporting and by investors in analysis. MLPs typically report another metric, Distributable Cash Flow, DCF, which is EBITDA less maintenance capex, which can be broadly interpreted as the amount of money required to keep EBITDA/DCF level. This does not take away from the validity of what Mr. Jun had to say about EBITDA as a metric for most companies but throw out the baby with the bath water. EBITDA is highly useful when analyzing high-yield companies and, iin particular, MLPs.
Extramiler - 7 years ago    Report SPAM
Good article, but be careful: Buffett never said to subtract "one time items" from Owner Earnings. In fact, he often criticized managements for playing the game of lumping their ordinary business losses into repeated quarterly "one time items". In the example from the 1986 letter, Buffett subtracted two non-cash accounting adjustments that were made after an acquisition.
William.b.thomson - 7 years ago    Report SPAM
I believe the author is correct in not including working capital changes in FCF.

My only objection to his analysis is that he overstates the case. Working capital changes can be cash flow positive if you are shrinking the business, which is not likely to be a positive development. Otherwise changes to working capital will probably be cash flow negative. As my Father once told me about his manufacturing business, he needed an extra dollar of working capital for every extra dollar of sales. The only other time working capital may be a source of funds is if management succeeds in becoming more efficient, which, while desirable, is not likely to be a normalized phenomena.

Thanks for the article.
Sorno - 7 years ago    Report SPAM
The author seems to have limited knowledge in accounting. There are several points that the author is not correct or even totally wrong:

1. "the amount of accounts receivables is really just an interest free loan to the customer" Nope, accounts receivable is the amount that business believes it can receive from the customers in the near future and it's based on assumption. That allows you to record a sale even tho the customers do not really commit to buy the item if you want to play the book. It's more than interest free loan because you can create the loan out of thin air. Adjust this account receivable means taking the assumption out of free cash flow.

2. "accounts receivables does not represent an increase in cash. Inventory also doesn’t bring in cash if it is sitting on the shelf. " No one said these two items represent a movement in cash, but the "increase/decrease" of these two items do. To understand this, you have to understand what implicity method of getting operating cash flow to do net income and how net income is obtained at the first place. E.g. If I build a house and sell it to a buyer at $100 with 100% financing (all happen within one year), assuming the cost of everything is $20, I can record a net income of $80 with INCREASE in account receivable of $100. The gaap operating cash flow shows: $80 - $100 = -$20. The gaap operating cash flow is obviously a more conservative measure because I actually put in $20 to build the house and the sale generates no cash to me. If the buyer just returns the house back to me without paying the loan, the income recorded at the first place is just wrong.

3. "believe Buffett calls his modified FCF formula as owner earnings" He never makes such call. It's others who tries to estimate owner earnings with FCF.

4. "he looks for great ongoing businesses with competitive advantages, not how much a company can give out at the end of the year." He actually cares about what a company can give out because he is good at resource allocation. This is why he said he let the managers to do whatever they want but buffett remains the final say of how to use the free resources. Buffett can use the cash to invest in somewhere else but he cannot use accounting profit.

5. "a company using the LIFO method will have a much lower inventory value compared to a company that uses the FIFO method..." This shows a lack of accounting knowledge. Changing LIFO, FIFO impacts the gross profit directly, so without adjusting the working capital, the number can change just because of a change in inventory policy. GAAP operating cash flow takes this problem out. You can see that net income always get adjusted after some years but operating cash flow almost always stay the same, that's because operating cash flow is not proned to accounting changes. Even if the change really impacts operating cash flow, it will impact YOUR fcf for sure because it follows the change in net income directly.

6. "Working capital can also vary drastically year to year which could provide an inaccurate picture of the business as well as affect the projected growth rate. " The fact is, profit changes a lot year to year for businesses, but accounting tricks smooth things out. Get the reality or a pretty picture painted by the management, your pick.
Batbeer2 premium member - 7 years ago
>>The author seems to have limited knowledge in accounting.

Don't we all ? Does anyone know of an investing guru who used to be an accountant ?

LwC - 7 years ago    Report SPAM
I believe that Bruce Berkowitz is an accountant by training and prior work experience.
Onthefringe - 5 years ago    Report SPAM
Question for the accountant, if you still visit this site (I know it has been three years). Or anyone else that may be able to answer this. Some of it may sound a bit technical:

So, basically subtracting increases in change in net working capital assumes that 1) an increase in any current asset is a use of cash or an equivalent to non-cash accounting income; 2) an increase in any current liability is a source of cash or delayed payment not reflected on the income statement.

I have a few questions on this. Looking at a random 10-k I see the following current assets and liabilities.

Current Assets

  • Cash and equivalents
  • Accounts receivable
  • Inventories
  • Deferred Income Tax
  • Prepaid expenses and other current assets

Current liabilities

  • Accounts payable
  • Notes payable
  • Current maturities of Obligations under capital leases
  • Accrued Expenses
  • Accrued non-recurring charges
  • Contingent Purchase Price payable
  • Income Taxes Payable
  • Deferred Income Tax

For the current assets I clearly understand how an increase in inventories, deferred income tax (amount actual taxes payable is greater than recorded on the income statement), prepaid expenses, and cash equivalents (using cash to purchase short term securities) are a use of cash. For current liabilities I completely understand how everything listed are reserves for upcoming payments.

I do not understand how an increase in plain vanilla cash on the balance sheet is considered a use of cash (you are ADDING cash from operations, interest, and other sources rather than spending it). I figure any changes to cold hard cash on the balance sheet would already be reflected in other portions of a free cash flow calculation.

So would a proper change in net working capital as reflected in an FCF calculation exclude changes in cold hard cash (rather than equivalents)? And do you not worry about this in the course of a normal valuation, since you are subtracting total excess cash from enterprise value?

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