The Complete Guide to Changes in Working Capita

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Jae Jun
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When a better tool (idea or approach) comes along, what could be better than to swap it for your old, less u
people, as Galbraith says, forever cling to their 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

It’s taken a lot of thought over many years to full understand this idea of what the “change” in changes in w
applied to valuation and financial analysis.

Here’s 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, it’s simply
current assets – current liabilities.
But what you really need to know about working capital is how and why it matters. That’s 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, that’s 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
analyzing and valuing companies.

Difference Between “Working Capital” and “Change in Working Capital

Let’s 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.
That’s 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
more assets than liabilities on the balance 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 stre
Note the emphasis on the word cycle. It’s not talking about a value from a single point in time. It’s referring
shorten.
What this also means is that when talking about working capital needs, you need to break it down to consi
Just like how capital expenditures can be broken down between growth capex and maintenance capex, working capital has to b

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, I’m going to take the numbers from the Cash Flow Statement of the Old Scho

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

 Detailed Breakdown Using Old School Value | Enlarge

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 that’s what the Wikipedia line is also pointing to.
companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stret
What the CHANGE Really 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. That’s the problem I fell into.
You should not just grab these items from the balance sheet and calculate the difference.
Here’s the wrong way of doing this because it’s 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 I’ve 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
screenshot.
The “change” refers to how the cash flow has changed based on the working capital changes. You have to
liability increases.
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
operating liabilities.

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

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 it’s not a good idea to grab the numbers from the balance sheet to calculate this.

But if you’re looking at a company where you can’t find the numbers from the cash flow statement for whatever reason, here’s

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

Let’s 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
positive. i.e. MSFT can grow with less capital.

Apple being more focused on the hardware side than Microsoft should show a negative change in working
capital than Microsoft to grow.
 Microsoft Changes in Working Capital | Enlarge

I’m 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
muscle to extend payments to reduce the capital needed to grow. The TTM number is lower than 2015 due
payables (being a good customer).
While there aren’t any red flags or signs of constant working capital needs by Microsoft, it’s not as good as
Compare this with Apple.

Apple Changes in Working Capital | Enlarge

A totally different story where change in working capital is consistently positive. Current operating liabilities
year.
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 Microsoft too.
Another comparison to study is Wal-Mart vs Amazon.com.

Walmart Changes in Working Capital | Enlarge

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

For such a capex heavy business, they’ve now worked to improve the way working capital is being used. P
faster than it was paying its bills.
It needed a lot more cash to keep growing. However, the big shift in 2015 is due to the huge leap in accoun
capital.
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 Working Capital | Enlarge

Over the past few years, Amazon is spending even more on inventory than Wal-Mart. Their accounts paya
awesome part. The rate at which they are collecting cash upfront before an item or service is provided is g

This is such a difference to the Wal-Mart model where money in equals item out. As Wal-Mart continues to
their numbers should shift to look more like 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 Buffett’s Owner E

The whole point of understanding changes in working capital is to know how to apply it to your cash flow c
Specifically, how do you use changes in working capital to calculate owner earnings?
Buffett’s 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 earnings.” These represent (a

Here’s how I interpreted it previously.

Buffett also mentions “additional working capital” in the paragraph. He says that additional working capital
given year where additional working capital is required to maintain the business, it should be included in ca
excluded from owner earnings.
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,
flows due to working capital.

The increment he is referring to is the increase in the current operating assets as mentioned above. Wheth
going to determine whether you include or exclude the change in working capital.

(You’ll 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 isn’t going into the specifics of whether to add or subtract the number. He is saying that you
the business is to affect the final owner earnings calculation.
It’s also a case by case basis.
Here’s the simple version.
 If the change in working capital is negative, that means working capital increased as the compan
flow and so it should reduce the owner earnings. (excluded in this case)

If changes in working capital is positive, that means working capital decreased as the company
with. This increases cash flow and so it should added to owner earnings. (included in this cas

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
depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1)
capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-te
business requires additional working capital to maintain its competitive position and unit volume, t
However, businesses following the LIFO inventory method usually do not require additional working capita

Microsoft Owner Earnings Example

Numbers and formatting is from Old School Value, follow along if you a member. You can get these numbe
 Microsoft Owner Earnings | Click to Enlarge

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, Microsoft’s 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 don’t 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. don’t do – -1,471 because it comes back to my error of focusing too much on the numbers and signs.
That’s 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 business
3. add or subtract the amount

Amazon Owner Earnings Example

I’m going to show 5 years of results for Amazon to show the hidden strength of what changes in working ca
 Amazon Owner Earnings Shows Underlying Strength of Company | Enlarge

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

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

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) 2011 2012 2013 2014
Change in Accounts Receivable $ (1,451.0) $ (1,156.0) $ (1,807.0) $ (1,120.0)
Change in Inventories $ (561.0) $ 184.0 $ (802.0) $ (161.0)
Change in Prepaid Expenses $ - $ - $ - $ -
Change in Other Current Assets $ (1,259.0) $ 493.0 $ (129.0) $ (29.0)
Change in Current Assets $ (3,271.0) $ (479.0) $ (2,738.0) $ (1,310.0)

Change in Accounts Payable & Accrued $ 58.0 $ (31.0) $ 537.0 $ 473.0

Change in Deferred Revenue $ - $ - $ - $ -
Change in Income Taxes Payable $ - $ - $ - $ -
Change in Other Current Liabilities $ (1,146.0) $ 410.0 $ 146.0 $ 1,075.0
Change in Current Liabilities $ (1,088.0) $ 379.0 $ 683.0 $ 1,548.0

Change in Working Capital $ (4,359.0) $ (100.0) $ (2,055.0) $ 238.0

Wal-Mart Stores (WMT)

Annual Statements ($ in millions) 2011 2012 2013 2014
Change in Accounts Receivable $ - $ - $ - $ -
Change in Inventories $ (3,205.0) $ (3,727.0) $ (2,759.0) $ (1,667.0)
Change in Prepaid Expenses $ - $ - $ - $ -
Change in Other Current Assets $ (733.0) $ (796.0) $ (614.0) $ (566.0)
Change in Current Assets $ (3,938.0) $ (4,523.0) $ (3,373.0) $ (2,233.0)

Change in Accounts Payable & Accrued $ 2,396.0 $ 1,752.0 $ 1,332.0 $ 634.0

Change in Deferred Revenue $ - $ - $ - $ -
Change in Income Taxes Payable $ (153.0) $ 994.0 $ 981.0 $ (1,224.0)
Change in Other Current Liabilities $ - $ - $ - $ -
Change in Current Liabilities $ 2,243.0 $ 2,746.0 $ 2,313.0 $ (590.0)
Change in Working Capital $ (1,695.0) $ (1,777.0) $ (1,060.0) $ (2,823.0)
 Apple Inc (AAPL)
2015 TTM Annual Statements ($ in millions) 2010
$ 1,456.0 $ 1,205.0 Change in Accounts Receivable $ 143.0
$ (272.0) $ (726.0) Change in Inventories $ 275.0
$ - $ - Change in Prepaid Expenses $ -
$ 62.0 $ 62.0 Change in Other Current Assets $ (1,934.0)
$ 1,246.0 $ 541.0 Change in Current Assets $ (1,516.0)

$ (1,054.0) $ (530.0) Change in Accounts Payable & Accrued $ 2,515.0

$ - $ - Change in Deferred Revenue $ 1,654.0
$ - $ - Change in Income Taxes Payable $ -
$ (624.0) $ (1,482.0) Change in Other Current Liabilities $ -
$ (1,678.0) $ (2,012.0) Change in Current Liabilities $ 4,169.0

$ (432.0) $ (1,471.0) Change in Working Capital $ 2,653.0

Amazon.com (AMZN)
2015 TTM Annual Statements ($ in millions) 2010
$ - $ - Change in Accounts Receivable $ (295.0)
$ (1,229.0) $ (1,053.0) Change in Inventories $ (1,019.0)
$ - $ - Change in Prepaid Expenses $ -
$ (569.0) $ (590.0) Change in Other Current Assets $ -
$ (1,798.0) $ (1,643.0) Change in Current Assets $ (1,314.0)

$ 3,927.0 $ 3,521.0 Change in Accounts Payable & Accrued $ 3,113.0

$ - $ - Change in Deferred Revenue $ 687.0
$ 166.0 $ (20.0) Change in Income Taxes Payable $ -
$ - $ - Change in Other Current Liabilities $ -
$ 4,093.0 $ 3,501.0 Change in Current Liabilities $ 3,800.0
$ 2,295.0 $ 1,858.0 Change in Working Capital $ 2,486.0
 2011 2012 2013 2014 TTM
$ (5,551.0) $ (2,172.0) $ (4,232.0) $ 611.0 $ 611.0
$ (15.0) $ (973.0) $ (76.0) $ (238.0) $ (238.0)
$ - $ - $ - $ - $ -
$ (1,414.0) $ 223.0 $ (2,220.0) $ (3,735.0) $ (3,735.0)
$ (6,980.0) $ (2,922.0) $ (6,528.0) $ (3,362.0) $ (3,362.0)

$ 4,467.0 $ 2,340.0 $ 5,938.0 $ 5,400.0 $ 5,400.0

$ 2,824.0 $ 1,459.0 $ 1,460.0 $ 1,042.0 $ 1,042.0
$ - $ - $ - $ - $ -
$ - $ - $ - $ - $ -
$ 7,291.0 $ 3,799.0 $ 7,398.0 $ 6,442.0 $ 6,442.0

$ 311.0 $ 877.0 $ 870.0 $ 3,080.0 $ 3,080.0

2011 2012 2013 2014 TTM

$ (866.0) $ (861.0) $ (846.0) $ (1,039.0) $ (1,682.0)
$ (1,777.0) $ (999.0) $ (1,410.0) $ (1,193.0) $ (1,982.0)
$ - $ - $ - $ - $ -
$ - $ - $ - $ - $ -
$ (2,643.0) $ (1,860.0) $ (2,256.0) $ (2,232.0) $ (3,664.0)

$ 4,064.0 $ 3,108.0 $ 2,624.0 $ 2,465.0 $ 3,729.0

$ 1,064.0 $ 1,796.0 $ 2,691.0 $ 4,433.0 $ 6,357.0
$ - $ - $ - $ - $ -
$ - $ - $ - $ - $ -
$ 5,128.0 $ 4,904.0 $ 5,315.0 $ 6,898.0 $ 10,086.0
$ 2,485.0 $ 3,044.0 $ 3,059.0 $ 4,666.0 $ 6,422.0