How do you account for changes in working capital and capital expenditures in FCF analysis?

1 What is working capital?

Working capital is the difference between a company's current assets and current liabilities. Current assets are cash and other assets that can be converted into cash within a year, such as inventory, accounts receivable, and prepaid expenses. Current liabilities are obligations that must be paid within a year, such as accounts payable, accrued expenses, and short-term debt. Working capital represents the amount of cash available to fund a company's day-to-day operations and growth. A positive working capital means that a company has more current assets than current liabilities, while a negative working capital means the opposite.

2 How does working capital affect FCF?

Working capital affects FCF because it reflects how much cash a company needs to invest or release from its operating cycle. A change in working capital is the difference between the working capital at the beginning and the end of a period. A positive change in working capital means that a company has increased its current assets or decreased its current liabilities, which implies that it has used more cash to fund its operations. A negative change in working capital means that a company has decreased its current assets or increased its current liabilities, which implies that it has freed up more cash from its operations. Therefore, to calculate FCF, you need to subtract a positive change in working capital or add a negative change in working capital from OCF.

3 What is CapEx?

CapEx is the amount of cash a company spends on acquiring or maintaining its long-term assets, such as property, plant, and equipment. CapEx reflects how much a company invests in its future growth and competitiveness. CapEx is usually reported as a separate line item in the cash flow statement under investing activities.

4 How does CapEx affect FCF?

CapEx affects FCF because it reduces the amount of cash available to shareholders or creditors. CapEx represents a cash outflow that reduces OCF. Therefore, to calculate FCF, you need to subtract CapEx from OCF. However, not all CapEx are equal. Some CapEx are necessary to maintain the existing level of operations, while others are discretionary and aimed at expanding or improving the operations. The former is called maintenance CapEx, while the latter is called growth CapEx. Depending on the purpose of FCF analysis, you may want to separate maintenance CapEx and growth CapEx and adjust FCF accordingly.

5 How to estimate working capital and CapEx?

Estimating working capital and CapEx can be challenging, especially for future periods. One approach is to use historical averages or ratios based on past financial statements. For example, you can calculate the average working capital as a percentage of revenue or the average CapEx as a percentage of depreciation. Another approach is to use projections or assumptions based on industry trends, competitive factors, or strategic plans. For example, you can forecast the growth rate of revenue or the expected amount of CapEx for new projects or acquisitions.

6 Why are working capital and CapEx important for valuation?

Working capital and CapEx are important for valuation because they affect the amount and timing of FCF, which is the basis for many valuation methods. For example, the discounted cash flow (DCF) method values a company by estimating the present value of its future FCFs. The higher the FCF, the higher the value. The lower the working capital and CapEx, the higher the FCF. However, working capital and CapEx also reflect the quality and sustainability of a company's operations and growth. The optimal level of working capital and CapEx depends on the industry, business model, and competitive position of a company. Too much or too little working capital or CapEx can indicate inefficiency, risk, or missed opportunities. Therefore, you need to account for working capital and CapEx in FCF analysis and understand their implications for valuation.