Calculate the Change in Working Capital and Free Cash Flow

This is the complete guide to understanding net working capital, calculating changes in working capital, and applying this to calculating Warren Buffett’s version of free cash flow, Owner Earnings. We’ll review the concepts, the formulas, and walk through several examples.

What You Will Learn

• What the “change” REALLY means in change in working capital
• The difference between “working capital” or “net 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. The spreadsheet includes examples, calculations, and the full article.

In fact, before you dive into it, I highly recommend you grab the companion spreadsheet in advance. That way you can follow along. Just click the image below to sign up and get it immediately in your inbox.

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.

Changes in Working Capital Basics

First, working capital is NOT the same as the change in working capital.

If you just want the definition of net working capital (NWC), it’s simply:

       current assets - current liabilities

The terms “working capital” and “net working capital” can be used interchangeably here. 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 means and 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 reason any business needs working capital is to continue operating the business. That’s the REAL purpose of working capital.

It’s 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 at 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’s 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:

Detailed Breakdown Using Old School Value | Enlarge

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. (Debt is strictly a financing choice for 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 delays the use of cash. Companies like this.

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.

Understanding Change in Working Capital

This is the difficult and confusing part so read and chew on it slowly so that you can digest it fully.

Ultimately, the change in working capital 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 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. Cash has been used, and this reduces Free Cash Flow.

If the Change in Working Capital is positive, the change in current operating liabilities has increased more than the current assets part. This means the use of cash has been delayed, which increases Free Cash Flow.

Put another way, if the change in working capital is negative, the company needs more capital to grow, and therefore working capital (not the “change”) is actually increasing.

If the 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 are also the key to calculating owner earnings properly which I get to further below.

Change in Working Capital Formula

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.

Calculating Change in Working Capital

Let’s compare the changes in working capital between Microsoft and Apple, and then Wal-Mart and Amazon.

Microsoft vs. Apple

Without showing you the numbers first, my initial guess is that because Microsoft is mainly a software business, their change in working capital should be positive. I.e., MSFT can grow with less capital.

Apple, being more focused on the hardware side than Microsoft, should show a negative change in working capital. Or even if it is positive, should require more capital than Microsoft to grow in absolute terms.

Microsoft Change in Working Capital | Enlarge

When we originally wrote this article, Microsoft’s working capital fluctuated a lot, with current assets generally increasing faster than current liabilities (increasing the need for cash to grow the business). The last three years looks much better, however, with current liabilities increasing faster than current assets. Current assets, in fact, have been decreasing, while current liabilities have been growing largely due to increases in deferred revenue and income taxes payable.

This really highlights Microsoft’s shift to a services/cloud company. All those increases in deferred revenue is cash it has actually received from subscribers to Azure, Office 365, etc., but which it’s recognizing over the course of the year. Software-as-a-Service (SaaS) businesses are great that way: collect money up-front and provide the service later over time. This is a great way to fund your own growth. And seeing this number grow rapidly for Microsoft is great news.

You can think of the increases in Income Taxes Payable similar to Accounts Payable. If this is increasing, the company is delaying the use of cash to pay income taxes to the government.

Compare this with Apple.

Microsoft Change in Working Capital | Enlarge

This is a totally different story where the change in working capital has turned negative in the last couple of years. Current operating assets have increased more than the operating liabilities.

Negative changes in working capital mean that the company needs more capital as it grows.

And Apple’s Deferred Revenue is not increasing, suggesting that one of its major future growth themes — services — has a long way to go, whereas Microsoft’s transition is well underway.

Based on just change in working capital alone, Microsoft today is the better and more efficient business.

In 2015, when we originally published this, the stories were the exact opposite. Now, Apple’s struggling a bit, and as a result, it’s relatively cheap compared to Microsoft. (For people counting Apple out now, it may be helpful to remember your attitude towards Microsoft in 2015!)

Wal-Mart vs. Amazon

Another comparison to study is Wal-Mart vs Amazon.com.

Wal-Mart Change in Working Capital | Enlarge

Surprising again because Wal-Mart has generally decreased its spending on inventory, except for 2017. For such a CapEx heavy business, they’ve improved the way their working capital is being used.

Previously, Wal-Mart kept having to pay for inventory faster than it was paying its bills. This made sense in the world of physical stores and no e-commerce. It grew mostly through new stores stocked with tons of inventory. It used to need a lot of cash to keep that up. Since 2015, however, it has been able to be much more efficient with its inventory, and it has really delayed its payments to vendors and suppliers, with its accounts payable growing each year.

It’s beginning to look a lot more like Amazon.

Amazon Change in Working Capital | Enlarge

Amazon gets cash up front, uses the cash to grow its business, then after a while provides the goods or services to the customer. That’s a great model, and you can see it in the reduction in its working capital needs for the year 2013-2016. But something changed in 2017.

Compared to Wal-Mart, which is increasing its inventory efficiency, Amazon is already extremely efficient and simply needs more inventory to meet demand. But deferred revenue is not keeping pace, which means a lot of this growth is not being paid for ahead of time. Instead, its Receivables are increasing, which means it’s getting paid after it delivers the product or service. This is definitely something to watch out for, especially since its Payables are not growing enough to make up the difference.

Using Change in Working Capital to Calculate Warren Buffett’s Version of Free Cash Flow: Owner Earnings

The whole point of understanding the change in working capital is to know how to apply it to your cash flow calculation when doing a DCF.

Specifically, how do you use changes in working capital to calculate owner earnings?

Buffett’s brief mention of working capital in his letter when he first brought up the idea of owner earnings honestly made things even more confusing.

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

Here’s how I interpreted it previously:

Buffett also mentions “additional working capital” in the paragraph. He says that additional working capital “should be included in (c)”. This means that on any given year where additional working capital is required to maintain the business, it should be included in CapEx. Otherwise, the rest of working capital should be excluded from owner earnings.

And this is where I got it wrong.

I was too caught up with whether it should be excluded or included and how to calculate it.

If you went through everything in this article up to this point to truly understand what the CHANGE means, Buffett is simply talking about the importance of cash flows due to working capital.

The increment he is referring to is the increase in the current operating assets as mentioned above. Whether the asset or liabilities side has the increment is going to determine whether you include or exclude the change in working capital.

(You’ll get it when I go through more examples further down.)

Buffett isn’t going into the specifics of whether to add or subtract the number. He is saying that you should think about how the cash flow requirements of the business affects the final owner earnings calculation.

It’s also a case by case basis.

Here’s the simple version:

• If the change in working capital is negative, that means working capital increased as the company used more capital to maintain its competitive position and unit volume. This reduces cash flow and so it should reduce the owner earnings.
• If the change in working capital is positive, that means working capital decreased as the company used less capital to maintain its competitive position and unit volume. This increases cash flow and so it should be added to owner earnings.

My problem was that I was looking at the numbers too much without seeing the entire picture of cash flow. This led to my mistakes in the calculations.

However, when you look and think about each component and simplify it to the two points above, it makes the entire calculation that much easier.

The overall owner earnings formula is still accurate.

     (a) Net Income
     +   (b) depreciation, amortization
     +/- (b) other non cash charges
     -   (c) annual maintenance capex (or the full capex)
     +/- changes in working capital

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.) – Buffett

Microsoft Owner Earnings Example

Numbers and formatting are from Old School Value, follow along if you a member. You can get these numbers from the SEC filings too and follow the examples.

Microsoft Owner Earnings | Enlarge

Using the TTM figures in millions:

• Net income = $18,819
• D&A = $10,599
• Other non cash charges = $1,263
• Capex = $13,102
• Changes in working capital = $19,192

Because the change in working capital is positive, it should increase FCF because it means working capital has decreased and that delays the use of cash.

Therefore, Microsoft’s TTM owner earnings come out to be:

18,819+10,599+1,263-13,102 + 19,192 = 34,245

Since the change in working capital is positive, you add it back to Free Cash Flow. That’s why the formula is written as +/- change in working capital.

The goal is to:

1. calculate the change in working capital
2. determine whether the cash flow will increase or decrease based on the needs of the business
3. add or subtract the amount

(It’s interesting that Microsoft’s Owner Earnings has stayed relatively flat over the last few years despite its improvements in working capital. CapEx increases are offsetting this, and Net Income hasn’t been growing with revenue, so there’s stuff to look at on the Income Statement.)

Amazon Owner Earnings Example

I’m going to show 4 years of results for Amazon to show the hidden strength of what changes in working capital can reveal when used with owner earnings.

Amazon Owner Earnings | Enlarge

Amazon’s change in working capital turned negative in 2017, and got even more negative for the trailing 12 months (3 quarters into 2018). Thus, it is subtracted from owner earnings as the company needs more capital to grow and so it will decrease cash flow.

Using the TTM figures in millions:

• Net income = $8,903
• D&A = $14,577
• Other non cash charges = $5,139
• Capex = $13,312
• Changes in working capital = -$2,223
• Owner Earnings = 8903 + 14577 + 5129 – 13312 – 2223 = 13,084

For most companies you analyze, by using the change in working capital in this way, the FCF calculation and owner earnings calculation is similar, as it was for Amazon and Microsoft.

Only when there are big differences in changes in working capital will you see a divergence between FCF and owner earnings.

Change in Working Capital Summary

The fundamental purpose of even discussing working capital is about cash flow needs of a business. Not the balance sheet calculation.

If an asset increases:

• the change in working capital is negative
• actual working capital increases
• cash flow is reduced
• subtract the change from cash flows for owner earnings

I.e., Asset increase = spending cash = reducing cash = negative change in working capital

If liability increases:

• the change in working capital is positive
• actual working capital decreases
• cash flow is increased
• add the change to cash flow for owner earnings

I.e., Liability increase = owing something = not spending cash upfront = increase in cash = positive change in working capital

References

• FCF calculation example using changes in working capital
• youtube video
• DCF calculation with the change in working capital explanation
• Prof Damodaran on non-cash working capital