Here’s what i noticed so far when you calculate the working capital component:
current assets excludes cash and equivalent
current liabilities excludes notes payable (even if they place it under current liabilities on the IS)
Just my two cents for everyone to take note of and feel free to add to the list.
Yes I agree with you. Working capital should exclude cash and payables. But why though?
because we’re dealing with FCFs or cash flow.
for the purpose of calculating FCFs, we’re trying to see where cash comes and goes.
an increase in CL means we have more cash (we defer payments for later date)
an increase in non-cash CA means we use up cash to buy those assets.
notes payables is excluded because it’s considered debt and is handled in net borrowing (relevant for the calculation of FCFE and not FCFF)
unfortunately, another use of working capital is to measure liquidity of the company and for this purpose, cash is included in WC.
if you have trouble understanding this, imagine a simple distributor business who buys inventory and sells them.
buy inventory at credit, AP goes up, Inventory goes up. net change in working capital (excluding cash) = 0, no effect on FCF.
buy inventory with cash, inventory goes up. net change in working capital (excluding cash) = positive, which reduces FCF. this is consistent because we use up cash.
sell inventory at credit, inventory goes down, AR goes up. net change in working capital (excluding cash) = 0, no effect on FCF
sell inventory for cash, inventory goes down. net change in working capital (excluding cash) = negative, which increases FCF. this is again consistent because we just received a cash inflow
if we include cash in the working capital adjustments, we can double count cash inflows and outflows.
Thanks edbert for the explanation!
I always think of working capital in terms of liquidity so i always include cash - must drop that mindset when it comes to FCF.
Another thing that came to mind is when to use FCFF and when to use FCFE.
-when leverage keeps changing, use FCFF
-how about when FCF is unstable - use FCFE right? But why?
Anyone have any other items to watch out for for FCF? I have missed these small items quite a few times, and who knows, they may cost you a few marks on the exam.
when FCF is unstable, you choose another method of valuation because forecasting unstable FCFs is not a good idea.
you can switch to something such as asset-based, residual income or market multiples.
How do we calculate FCF? I know the the formula for FCFF and FCFE. How about FCF?