Forecasting Working Capital and Capex
Growth is not free. Rising sales tie up cash in net working capital and demand capital expenditure to expand capacity, and both are real cash uses that depress free cash flow even when profit looks healthy. Working-capital lines are forecast from operating ratios, receivables from the collection period, inventory from turnover and payables from the payment period. Capex is forecast from a capacity or sales-to-assets schedule, with depreciation driven off the prior period’s asset base. The valuation cares about the change in net working capital and the level of capex, since subtracts and but adds back non-cash depreciation.
Why it matters
A growing firm has to bankroll its own growth before customers pay. It buys inventory, extends credit on sales, and lays out cash for new plant, all ahead of the cash coming back. That is why a profitable company can still bleed cash. The forecasting move is to tie each operating asset and liability to its driver rather than guess a balance. Receivables follow how long customers take to pay, inventory follows how fast it sells, payables follow how long the firm takes its own suppliers. Only the increase in net working capital is a cash use, so a flat working-capital balance consumes no cash even though its level is large.
Formulas
Worked examples
Sales rise from US$100m to US$120m. Receivables hold at 45 days, inventory at 60 days of cost of goods sold (which runs at 65 percent of sales), and payables at 30 days of that cost. Capex is US$15m and depreciation US$9m. Estimate the change in net working capital and its drag on free cash flow.
At base, receivables are 45 times US$100m over 365, about US$12.3m, inventory is 60 times US$65m over 365, about US$10.7m, and payables are 30 times US$65m over 365, about US$5.3m, so base net working capital is roughly US$17.7m. At US$120m sales, cost of goods sold is US$78m, giving receivables about US$14.8m, inventory about US$12.8m and payables about US$6.4m, so net working capital is about US$21.2m. The change is roughly US$3.5m of cash tied up by growth. Inside free cash flow that US$3.5m is subtracted, capex of US$15m is subtracted, and the US$9m of non-cash depreciation is added back, so growth consumes cash well beyond what the profit line suggests.
Common mistakes
- ✗The level of net working capital is the cash drain. Only the change in net working capital affects free cash flow. A large but stable balance consumes no fresh cash in the period.
- ✗Depreciation is a cash outflow to forecast. Depreciation is a non-cash charge added back in the cash build. The genuine cash use for long-lived assets is capital expenditure.
- ✗Capex equals depreciation in every forecast year. For a growing firm capex usually exceeds depreciation, because it must add capacity rather than merely replace worn assets.
- ✗Working capital can be forecast as one blended ratio. Receivables, inventory and payables have different drivers, so each is best tied to its own operating ratio.
Revision bullets
- •Growth ties up cash in working capital and demands capex
- •Receivables follow the collection period, inventory the turnover, payables the payment period
- •Capex follows a capacity or sales-to-assets schedule
- •Depreciation is driven off the prior period’s asset base
- •Free cash flow subtracts the change in NWC and capex, and adds back depreciation
- •A growing firm’s capex usually exceeds its depreciation
Quick check
In a free-cash-flow forecast, which item reduces cash flow as sales grow?
For a growing company, forecast capital expenditure typically
Connected topics
Sources
- Titman & Martin, Ch. 6Titman, S., & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.Forecasts working-capital accounts from operating ratios and converts pro-forma statements into free cash flow.
- Koller, Goedhart & Wessels (2020), Ch. 13Koller, T., Goedhart, M., & Wessels, D. Valuation: Measuring and Managing the Value of Companies. 7th ed. McKinsey & Company / Wiley, 2020.Models capital expenditure and working-capital investment as the cash cost of growth in free cash flow.