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Online Tutorial #4: How Do You Calculate A Company's "Incremental Net Working Capital" Needs?

Incremental investment in net working capital is another important value driver in a calculation of shareholder value. This session focuses on where to find the data, how to calculate historical working capital trends and how to project future working capital needs. As with previous sessions, we will use Gateway, Inc., as of April 21, 2000, as a case study. Readers who want to calculate working capital  while reading this tutorial may wish to download the accompanying spreadsheet. 

What Does "Net Working Capital" Mean?

To understand what we mean by "net working capital," let's break this phrase down into its component parts:

  • Net. This means we look at cash tied up in short term operating assets such as accounts receivable and inventory, offset by non-interest bearing current liabilities such as accounts payable.
  • Working. This means that we want to focus on cash tied up in short term operating assets. Thus, working capital excludes long term capital required for, say, investment in Plant, Property and Equipment (PP&E).
  • Capital. This means that we want to calculate the amount of cash that a company has to tie up in working capital  in order to run its business.

More specifically, for industrial companies, "net working capital" equals cash tied up by a company's short term operating assets, netted against short term operating liabilities.

For any year, then, we add and subtract the following to calculate a company's net working capital:

  1. Required cash. We usually assume that a company needs to have some cash on hand to run its business. We can estimate that sum as a fixed amount of cash, or an amount as a percentage of sales. Thus, we add required cash to calculate working capital.
  2. Accounts receivable (A/R). Accounts Receivable equals money owed to a company for goods or services purchased on credit. As A/R grow, then, a company needs to tie up cash in its business as it effectively lends this money out. Thus, we add accounts receivable to calculate working capital.
  3. Inventory. Any company selling a physical product will have to tie up cash in raw materials, work-in-progress and finished goods inventory. Thus, we add inventory to calculate working capital.
  4. Other current assets. A company may have to tie up cash in other current assets, such as insurance pre-payments. Thus, we add other current assets to calculate working capital.
  5. Accounts payable. Accounts Payable equal bills from suppliers for goods or services purchased on credit. A company benefits from accounts payable just like consumers benefit from a charge card: you enjoy the merchandise now, and pay later. Thus, we subtract accounts payable to calculate working capital.
  6. Deferred or Unearned Revenue. Some companies get paid in cash by their customers before those companies deliver a promised product or service. As an example, you may have purchased a warranty for a product, whereby you gave a company cash in advance for a promised service: the ability to have that product replaced or fixed in the event it became defective. Until the warranty ends, the company has the obligation to provide this service to you, so it must recognize this cash received as a liability. Thus, we subtract deferred revenue to calculate working capital.
  7. Other non-interest bearing current liabilities. Various companies may have assorted non-interest bearing current liabilities such as accrued wages, accrued expenses, accrued royalties, or "other accrued liabilities." These non-interest bearing current liabilities generate cash as they increase. Thus, we subtract other non-interest bearing current liabilities to calculate working capital.
Case Study: Gateway, Inc., as of April 21, 2000

 

To calculate Gateway's net working capital, we first need to obtain the seven data points described above from the company's historical SEC filings. (Click the relevant year to see Gateway's balance sheet: 1995, 1996, 1997, 1998, or 1999.)

We have used these balance sheets to assemble a table that excerpts the current assets and current liabilities portion of Gateway's balance sheet (below). We highlight those items that directly enter into a calculation of net working capital:

  1994 1995 1996 1997 1998 1999
   Cash 214.0 166.4 516.4 593.6 1,169.8 1,127.7
   Short-term investments 29.9 3.1 0.0 38.6 158.7 208.7
   Accounts receivable 252.9 405.3 449.7 510.7 558.9 646.3
   Inventories 120.2 224.9 278.0 249.2 167.9 191.9
   Other current assets 37.1 66.6 74.2 152.5 172.9 522.2
   Deferred income taxes 0.0 0.0 0.0 0.0 0.0 0.0
Current assets 654.2 866.2 1,318.3 1,544.7 2,228.2 2,696.8
   Accounts payable 183.3 235.1 411.8 488.7 718.1 898.4
   Notes payable 3.8 13.6 15.0 14.0 11.4 5.5
   Accrued expenses 57.8 109.0 190.8 271.3 415.3 609.1
   Accrued royalties 85.8 123.4 125.3 159.4 167.9 153.8
   Other accrued liabilities 18.2 44.3 56.9 70.6 117.1 142.8
Current liabilities 348.9 525.3 799.8 1,003.9 1,429.7 1,809.7

 

After entering this data into the Inputs worksheet of the "Working Capital.xls" spreadsheet , we can calculate net working capital by adding  the relevant current operating assets and subtracting the relevant current operating liabilities.

We do this in the table below:

 

 

1995

1996

1997

1998

1999

Required cash (2% of sales)

74

101

126

149

173

A/R

405

450

511

559

646

Inventory

225

278

249

168

192

Other current assets

67

74

153

173

522

Current operating assets

770

903

1038

1049

1533

Accounts payable

235

412

489

718

898

Accrued expenses

109

191

271

415

609

Accrued royalties

123

125

159

168

154

Other accrued liabilities

44

57

71

117

143

Current operating liabilities

512

785

990

1418

1804

Net working capital

259

118

48

-369

-271

The last step of the analysis calculates  how much cash Gateway typically ties up in working capital to generate a dollar of new sales.

 

 

1994

1995

1996

1997

1998

1999

Net working capital

    119

    259

     118

       48

   (369)

   (271)

Incremental working capital

     (33)

    139

   (141)

     (70)

   (418)

       98

Sales

 2,701

 3,676

  5,035

 6,294

  7,468

 8,646

Incremental sales

    970

    975

  1,359

 1,259

  1,174

 1,178

Incremental working capital (% of sales)

-3.4%

14.3%

-10.3%

-5.5%

-35.6%

8.3%

Incremental working capital over last 5 years (%)

 

 

 

 

 

-6.6%

 

Here, we see that--unlike most companies--Gateway's net working capital tends to generate cash from year to year. Over the five year period, we see that Gateway's net working capital has fallen from $119 million to negative $271 million--a fall of $336 million--while sales have increased from $2.7 billion to $8.6 billion--an increase of $5.9 billion. Over this period, then, Gateway's "incremental working capital as a percentage of sales" equals negative $336 million divided by $5.9 billion, or (6.6)%.

How Do You Project Future "Incremental Working Capital (%)"?

In Gateway's case, the company's historically tight working capital management leads us to anticipate little future variability. We project incremental working capital as a percentage of incremental sales to be approximately (5.0)%, similar to the company's historical average.


 

Sidebar: Cash Conversion Cycle

In cases where working capital tends to be more volatile or trend in a particular direction, "cash conversion cycle" analysis offers an intuitive way of thinking about, and projecting, working capital. The cash conversion cycle quantifies the time between cash payment to suppliers and cash receipt from customers.

The three components of the cash conversion cycle are as follows:

1. Days sales outstanding (DSO). The number of days between the sale of a product and the receipt of a cash payment. The formula is: DSO = Days in year (360) / (Sales / Average accounts receivable).

2. Days in inventory (DII). The number of days it takes for a company to convert its raw material, work-in-progress and finished goods inventory into product sales. The formula is: DII = Days in year (360) / (Cost of goods sold / Average inventory).

3. Days payables outstanding (DPO). The number of days between the purchase of an input from a vendor and cash payment to that vendor. The formula is: DPO = Days in year (360) / (Cost of goods sold / Average accounts payable).

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