Working Capital in FCF for Valaution Purposes

[Ecko747]

I would like if I may, to get your insight on why Changes in Working capital are relevant to calculating FCF for valuation purposes as I currently hold the opinion that it is largely not and would appreciate your insight.

In calculating Working capital for valuation purposes text books focus on current liabilities (net of cash) and Current liabilities ( all non-interest earning debt, but including Supplier credit, accounts payable and accrued items (salaries, taxes etc)).

For me at least, it makes sense to measure changes inventories because it represents cash tied up-within firm that may be crucial to its operations (almost like a form of capex especially for the retail sector). Moreover, the value of inventories may appreciate representing an asset gain or conversely depreciate, or never be utilized in sales (in which case would constitute an expense). All of which would affect the value of the firm

However (and my question is) why are changes in receivables and payables included in free cash flow ?

Effectively a Receivable is an interest free loan to made to the customer while a payable is more or less credit extension by a company’s suppliers. In the case of receivables I view them as earnings in transit, where the cash here is actually rightfully owned by the firm. In the case of Payables I see this as largely interest free borrowings but more importantly cash that is not owned by the firm.

It is my observation that increase in accounts payable overstate FCF and increases in accounts receivables understate FCF.

If I were looking at this from a credit or liquidity perspective – factoring both makes sense.

However, if I am looking at this from an Owner Earnings Perspective, then changes in payables and receivables I believe distort the value of the firm.

This is the impression I have received from reading Berkshire Hathaway’s 1986 Chairman’s letter to Shareholders. Where Warren Buffett purposes:

Owner earnings = Net income + depreciation & amortization +/- one-time items - capital expenditures

[wsthost]

The idea behind changes in working capital is that when you value (or buy) an entity, you are buying the company on a going concern basis, able to support its own operations. if you agreed to purchase a company for $100 and it turns out that you still have to put in $10 MORE because there was no working capital left on the books, then in essence, you really paid $110 for the company. Thus, in purchase agreements, there is always a negotiated and agreed upon working capital requirement. In the case of FCFF, it's the same concept - because you have to continue to support your operations, this reduces the amount of cash that you can receive, that is, the amount of "free" or "excess cash generated" is reduced by this obligation.

If you agree that Inventories should be part of the working capital calculation, then you should also see why A/P and A/R are. They are due to operations; in the case of A/R, you sold good (sales) but haven't yet collected and yet, you need to pay your suppliers & vendors (COGS) and thus, those are all cash impacts, the net of which is the change in working capital. Just like you have to buy inventory to support COGS & Sales!!

Please don't overthink it. A/P is NOT an interest free loan or borrowing, it is trade credit. You are correct in your assessment of A/R being earnings in transit and thus, unless you collect immediately on everything you sell, you will have to support that trade credit to your customers; hence a working capital item required to support day-to-day operations. A/P is the same concept, but reversed. Thus, both are included in working capital cahnges.