The Complete Guide to Changes in Working Capita

Written by
Jae Jun
follow me on

Facebook
Twitter

When a better tool (idea or approach) comes along, what could be better than to swap it for your old, less u
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 at the bottom of the post, because the whole topic of c

Its taken a lot of thought over many years to full understand this idea of what the change in changes in w
Heres another quote from Munger before I dive into things as it sums up this topic well.

Getting Back to the Basics of Change in Working Capital

First, working capital is NOT the same as the change in working capital.
If you just want the definition of working capital, its simply
current assets current liabilities.

But what you really need to know about working capital is how and why it matters. Thats where the chang

Previously, I concluded that it was all about the difference from the current year and the previous year.

From an accounting standpoint and definition, thats correct and what the following articles and explanation
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 chang

Difference Between Working Capital and Change in Working Capital

Lets 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 p
However, the real purpose any business needs working capital is to continueoperating the business.
Thats the REAL purpose of working capital.

Not to see whether there are more current assets than current liabilities. If you are a business owner, it ma
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 stret

Note the emphasis on the word cycle. Its not talking about a value from a single point in time. Its referring

What this also means is that when talking about working capital needs, you need to break it down to consid

Just like how capital expenditures can be broken down between growth capex andmaintenance capex

Another name for this is non cash working capital, because current assets includes cash, which is not us
To save time and for simplicity sake as I write this, Im going to take the numbers from the Cash Flow

This is how the change in cash flow section is broken down.

Detailed Breakdown Using Old

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.
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 requires delaying the use of cash.

And thats what the Wikipedia line is also pointing to.

companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretc

What the CHANGEReally Stands For

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

Ultimately, the change does not mean the difference. Thats the problem I fell into.
You should not just grab these items from the balance sheet and calculate the difference.
Heres the wrong way of doing this because its so easy to get things mixed up and get an incorrect numb
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 Ive 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 fro

The change refers to how the cash flow has changed based on the working capital changes. You have to
If current assets is increasing, cash is being used.

If current liabilities part is increasing, less cash is being used as the company is stretching out payments o

To tie this together, the change is about determining whether current operating assets or current operatin

If the final value for Change in Working Capital is negative, that means that the change in the current oper

If Changes in Working Capital is positive, the change in current operating liabilities has increased more th

Put another way, if changes in working capital is negative, the company needs more capital to grow, and th

If change in working capital is positive, the company can grow with less capital because it is delaying paym

These two last sentences is also the key to calculating owner earnings properly which I get to further below

The Calculation of Changes in Working Capital

Earlier, I said its not a good idea to grab the numbers from the balance sheet to calculate this.

But if youre looking at a company where you cant find the numbers from the cash flow statement for

Changes in Working Capital

= Previous Working Capital New Working Capital
= (Previous Current Assets Previous Current Liabilities) - (New Current Assets New Current Liabilities)
= (Previous Current Assets New Current Assets) + (New Current Liabilities Previous Current Liabilities)

Change in Working Capital Examples

Lets compare the changes in working capital between Microsoft and Apple, and then Wal-Mart and Amazo

Without showing you the numbers first, my initial guess is that because Microsoft is mainly a software busi

Apple being more focused on the hardware side than Microsoft should show a negative change in working

Microsoft Changes in Worki

Im surprised with the change in working capital for Microsoft, as it fluctuates regularly.

If you go through the items, the takeaway here is that Microsoft is collecting more from its AR balance and
needed to grow. The TTM number is lower than 2015 due to an increase in inventory and lower account pa

While there arent any red flags or signs of constant working capital needs by Microsoft, its not as good as
Compare this with Apple.

Apple Changes in Working

A totally different story where change in working capital is consistently positive. Current operating liabilities
Positive change in working capital means that the company needs less capital to grow.
Based on just change in working capital alone, Apple is the better and more efficient business.
Better value than Microsofttoo.

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

Walmart Changes in Workin

Surprising again because Wal-Mart is spending less on inventory since 2014.

For such a capex heavy business, theyve now worked to improve the way working capital is being used. P

It needed a lot more cash to keep growing. However, the big shift in 2015 is due to the huge leap in accoun
i.e. they are delaying payments to vendors and suppliers to improve their cash flow.
Amazon on the other hand does things very differently.

Amazon Changes in Workin

Over the past few years, Amazon is spending even more on inventory than Wal-Mart. Their accounts paya
collecting cash upfront before an item or service is provided is growing exponentially.

This is such a difference to the Wal-Mart model where money in equals item out. As Wal-Mart continues to
Amazon going forward.

Amazon is able to accept the cash first, use it to grow operations, then after a while provide the goods or s

Using Change in Working Capital to Calculate Warren Buffetts Owner E

The whole point of understanding changes in working capital is to know how to apply it to your cash flow ca
Specifically, how do you use changes in working capital to calculate owner earnings?

Buffetts brief mention of working capital in his letter when he first brought up the idea of owner earnings ho

If we think through these questions, we can gain some insights about what may be called owner earn

Heres how I interpreted it previously.

Buffett also mentions additional working capital in the paragraph. He says that additional working capital
required to maintain the business, it should be included in capex. Otherwise, the rest of working capital sho
And this is where I got it wrong.
I was too caught up with whether it should 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,

The increment he is referring to is the increase in the current operating assets as mentioned above. Wheth
exclude the change in working capital.
(Youll get it when I go through more examples further down.)
Wal-Mart has to continually buy more inventory to maintain its competitive position and unit volume.
Again, Buffett isnt going into the specifics of whether to add or subtract the number. He is saying that you
earnings calculation.
Its also a case by case basis.
Heres the simple version.

If the change in working capital is negative, that means working capital increased as the com
earnings. (excluded in this case)

If changes in working capital is positive, that means working capital decreased as the compa
should added to owner earnings. (included in this case)
My problem was that I was looking at the numbers too much without seeing the entire picture of cash flow.
However, when you look and think about each component and simplify it to the two points above, it makes
The overall owner earnings formula is still accurate.
Owner Earnings =
(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
other non-cash charges such as Company Ns items (1) and (4) less ( c) the average annual amount of ca
long-term competitive position and its unit volume. (If the business requires additional working capital
in ( c) . However, businesses following the LIFO inventory method usually do not require additional workin

MicrosoftOwner Earnings Example

Numbers and formatting is from Old School Value, follow along if you a member. You can get these numbe

Microsoft Owner Earnings

Using the TTM figures in millions:

Net income = $12,273
D&A = $5,990
Other non cash charges = $2,598
Capex = $6,018
Changes in working capital = ($1,471)

Because changes in working capital is negative, it should reduce FCF because it means working capital ha
Therefore, Microsofts TTM owner earnings comes out to be:
12,273+5,990+2,598-6,018 - 1,471 = 13,372
Although the change in working capital is negative, you dont subtract it to do a double negative.
In math form, all I did was
12,273+5,990+2,598-6,018 + -1,471 = 13,372
i.e. dont do -1,471 because it comes back to my error of focusing too much on the numbers and signs.

Thats why the formula is written as +/- changes 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 busines
3. add or subtract the amount

AmazonOwner Earnings Example

Im going to show 5 years of results for Amazon to show the hidden strength of what changes in working ca

Amazon Owner Earnings Shows Underlyin

Unlike Microsoft or Wal-Mart, Amazon changes in working capital is positive. It is added to the owner earni

Using the TTM figures in millions:

Net income = $328
D&A = $5,909
Other non cash charges = $2,001
Capex = $4,424
Changes in working capital = $6,422
Owner Earnings = 328 + 5909 + 2001 4424 + 6422 = 10,236
And because of the strength in their business model, the owner earnings greatly outpaces the standard FC

For most companies you analyze, by using the change in working capital in this way, the FCF calculation a

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

Rules of Thumb and Summary

The fundamental purpose of even discussing working capital is about cash flow needs of a business. Not t
If an asset increases:
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:
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

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

Microsoft Corporation (MSFT)

Annual Statements ($ in millions)
Change in Accounts Receivable
Change in Inventories
Change in Prepaid Expenses
Change in Other Current Assets

$
$
$
$

Change in Current Assets

$
$
$
$

2012
(1,156.0)
184.0
493.0

(3,271.0) $

(479.0)

$
$
$
$

58.0
(1,146.0)

$
$
$
$

(31.0)
410.0

Change in Current Liabilities

(1,088.0) $

379.0

Change in Working Capital

(4,359.0) $

(100.0)

Change in Accounts Payable & Accrued Expenses

Change in Deferred Revenue
Change in Income Taxes Payable
Change in Other Current Liabilities

2011
(1,451.0)
(561.0)
(1,259.0)

Wal-Mart Stores (WMT)

Annual Statements ($ in millions)
Change in Accounts Receivable
Change in Inventories
Change in Prepaid Expenses
Change in Other Current Assets
Change in Current Assets

2011

2012

$
$
$
$
$

(3,205.0)
(733.0)
(3,938.0)

$
$
$
$
$

(3,727.0)
(796.0)
(4,523.0)

Change in Accounts Payable & Accrued Expenses

Change in Deferred Revenue
Change in Income Taxes Payable
Change in Other Current Liabilities
Change in Current Liabilities
Change in Working Capital

$
$
$
$
$
$

2,396.0
(153.0)
2,243.0
(1,695.0)

$
$
$
$
$
$

1,752.0
994.0
2,746.0
(1,777.0)

$
$
$
$

2013
(1,807.0)
(802.0)
(129.0)

$
$
$
$

(2,738.0) $

$
$
$
$

537.0
146.0

683.0 $

(2,055.0) $

$
$
$
$

2013

2014
(1,120.0)
(161.0)
(29.0)

$
$
$
$

(1,310.0) $
473.0
1,075.0

$
$
$
$

1,548.0 $
238.0

2014

2015
1,456.0
(272.0)
62.0

$
$
$
$

TTM
1,205.0
(726.0)
62.0

1,246.0 $

541.0

(1,054.0)
(624.0)

$
$
$
$

(530.0)
(1,482.0)

(1,678.0) $

(2,012.0)

(432.0) $

2015

(1,471.0)

TTM

$
$
$
$
$

(2,759.0)
(614.0)
(3,373.0)

$
$
$
$
$

(1,667.0)
(566.0)
(2,233.0)

$
$
$
$
$

(1,229.0)
(569.0)
(1,798.0)

$
$
$
$
$

(1,053.0)
(590.0)
(1,643.0)

$
$
$
$
$
$

1,332.0
981.0
2,313.0
(1,060.0)

$
$
$
$
$
$

634.0
(1,224.0)
(590.0)
(2,823.0)

$
$
$
$
$
$

3,927.0
166.0
4,093.0
2,295.0

$
$
$
$
$
$

3,521.0
(20.0)
3,501.0
1,858.0

Apple Inc (AAPL)

Annual Statements ($ in millions)
Change in Accounts Receivable
Change in Inventories
Change in Prepaid Expenses
Change in Other Current Assets

$
$
$
$

Change in Current Assets

Change in Accounts Payable & Accrued Expenses

Change in Deferred Revenue
Change in Income Taxes Payable
Change in Other Current Liabilities

2010
143.0
275.0
(1,934.0)

$
$
$
$

(1,516.0) $

$
$
$
$

2,515.0
1,654.0
-

$
$
$
$

Change in Current Liabilities

4,169.0 $

Change in Working Capital

2,653.0

Annual Statements ($ in millions)

Change in Accounts Receivable
Change in Inventories
Change in Prepaid Expenses
Change in Other Current Assets
Change in Current Assets

$
$
$
$
$

2010
(295.0)
(1,019.0)
(1,314.0)

Change in Accounts Payable & Accrued Expenses

Change in Deferred Revenue
Change in Income Taxes Payable
Change in Other Current Liabilities
Change in Current Liabilities
Change in Working Capital

$
$
$
$
$
$

3,113.0
687.0
3,800.0
2,486.0

2011
(5,551.0)
(15.0)
(1,414.0)

$
$
$
$

2012
(2,172.0)
(973.0)
223.0

(6,980.0) $

(2,922.0)

4,467.0
2,824.0
-

$
$
$
$

2,340.0
1,459.0
-

7,291.0 $

3,799.0

311.0 $

877.0

Amazon.com (AMZN)
$
$
$
$
$

2011
(866.0)
(1,777.0)
(2,643.0)

$
$
$
$
$

2012
(861.0)
(999.0)
(1,860.0)

$
$
$
$
$
$

4,064.0
1,064.0
5,128.0
2,485.0

$
$
$
$
$
$

3,108.0
1,796.0
4,904.0
3,044.0

$
$
$
$
$

2013
(4,232.0)
(76.0)
(2,220.0)

$
$
$
$

(6,528.0) $

$
$
$
$

5,938.0
1,460.0
-

$
$

$
$
$
$

TTM
611.0
(238.0)
(3,735.0)

(3,362.0) $

(3,362.0)

$
$
$
$

5,400.0
1,042.0
-

7,398.0 $

6,442.0 $

6,442.0

870.0 $

3,080.0 $

3,080.0

$
$
$
$
$

2013
(846.0)
(1,410.0)
(2,256.0)

$
$
$
$
$
$

2,624.0
2,691.0
5,315.0
3,059.0

$
$
$
$

2014
611.0
(238.0)
(3,735.0)

5,400.0
1,042.0
-

$
$
$
$
$

2014
(1,039.0)
(1,193.0)
(2,232.0)

$
$
$
$
$

TTM
(1,682.0)
(1,982.0)
(3,664.0)

$
$
$
$
$
$

2,465.0
4,433.0
6,898.0
4,666.0

$
$
$
$
$
$

3,729.0
6,357.0
10,086.0
6,422.0