I was wondering if somebody could clarify what to include in the calculations of NWC (FCF)? I’m currently looking at Coca-Cola’s balance sheet (see below for CA and CL). My thinking:
Do not include 1, 9 and 10 as they are financing activities. - Include 4, 5 and 8. The classics. - Do not include 2 and 3. Basically the same as 1? - Include the rest. Wild guess.
Can someone please explain to me what to include? Not just in this case but for future cases with different balance sheets. I’m a little bit confused.
Thanks in advance. Very much appreciate it.
Current assets:
Cash and cash equivalents 2. Short-term investments 3. Marketable securities 4. Trade accounts receivable 5. Inventories 6. Prepaid expenses and other assets 7. Assets held for sale Current liabilities: 8. Accounts payable and accrued expenses 9. Loans and notes payable 10. Current maturities of long-term debt 11. Accrued income taxes 12. Liabilities held for sale
I agree with these. The rest are 6, 7, 11 and 12. I would include in calculation of net working capital 6 and 11 but not 7 and 12.
I am pretty sure a change in Accrued taxes and expenses shall be included. Assets and liabilities held for sale sound more like investing / financing instead of operating activity.
Aside from 4, 5 and 8, I would also include 6 but not 11. The point of looking at working capital is often to understand the impact of changing trade terms on the balance sheet and (more importantly) cash flow. Including accrued taxes, a balance sheet position which often moves without direct relation to current trading, will only muddle the picture in my view.
You can also offset 7 against 12 to obtain a net value of assets for sale, as often the two are related (eg asset and the accompanying liability), although this is separate from working capital.
I do agree that the “held for sale” posts (7 and 12) are unlikely to be included in NWC. However, i’m very confused when it comes to 6 and 11. Some say include it, and some say leave it out. Is there no definitive answer? Outside of the classics (Inventories, payables, etc) one have to make an “educated guess” on what to include?
Regarding 11 accrued income taxes- in Reading 34 Free Cash Flow Valuation example 6 accrued taxes and expenses are included in calculation of net working capital.
As to 6 - I haven’t met such case in CFAI curriculum. My logic is that if you include in calculation accrued expenses you would include prepaid expenses too. Broadly speaking, working capital is defined as current assets (excluding cash and equivalents) minus current liabilities (excluding short-term debt). The “life” of prepaid or accrued expenses in generally less than a year.
Net working capital is meant to reflect the cash investment required for the business to operate on an on-going basis, so it depends on the industry you are in.
For a generic manufacturing co., things like inventory are needed to sell products, and all purchases and sales are done on some form of n/30 credit through payables and receivables. You will never have no inventory and no a/p or a/r if you continue to operate your business. If you do, you are probably aren’t running your business that efficiently (ie, stalling to produce more inventory, only doing sales for cash, and only purchasing inputs for cash).
Since we value companies as an indefinite, on-going business, our assumption is we will always have to have some level of cash invested in these working capital items to run our business and produce cashflows. This money is never extractable (unless the company is liquidated), so it needs to be deducted from our cash flow estimates.
This is why inventory and account management is important, and why the CFA teaches the DSO, DPO, and inventory turnover calcs. Firms that manage these better require less cash invested to operate, which means more cash for us investors.
Prepaid expenses traditionally isn’t included because it is not a true working capital item. You’ll have to look into the notes and see what is included. If its something management has a lot of discretion over, then I would include it. If its something that management doesn’t have a lot of discretion over, and is just a result of lumpy payments like insurance premiums, then I wouldn’t include it. In your case specifically, you have ‘other assets’ tagged onto the line. You need to be extra careful and see what is included in that line.
Taxes are not included because they are just the result of differences in cash taxes versus accounting taxes. You could argue management could have slight discretion and control over these, but this is not part of normal operations, and tax assets and liabilities are expected to reverse over time (also taught in the CFA!).
Discretion - the freedom to decide what should be done in a particular situation.
So basically what I mean is, is it something management can fully manage and control, such as inventory levels, or is it something they can’t control, or can only partially control.