JAMES P. WESTON: Hi. Welcome back to Finance for Non-Finance Professionals. This week, we're talking about measuring cash flow, and we're going to come up with our measure of free cash flow. And we're going to work through each of the parts of the formula for free cash flow. In this lesson, we're going to talk about working capital and how that affects our measurement of free cash flow. OK. What is working capital? Working capital is, in a very basic accounting definition, current assets-- stuff that I have that's kind of short term, minus current liabilities-- stuff that I owe that's kind of short term. And we're going to walk through what that means in terms of cash. It's a measure of operating liquidity because it kind of tells me how much money the firm has in its wallet. Well, why does that matter how much cash the firm has in its wallet? Because that represents an opportunity cost. If I go to the bank, and I take money out of my bank account and stick it in my wallet, that's working capital. It's working capital that I can't deploy elsewhere in the firm. It's money that I've got tied up in either payables or receivables or inventory. We'll talk about it. And it's money that I can't sort of deploy. It represents an opportunity cost. We're going to have to account for in a measure of free cash flow. It's not included in the income statement as an expense, but it is a real cash flow or drain on the firm. And so we've got to account for it when we calculate free cash flows. Let's talk first about current liabilities. That's stuff that I owe to other people that's due in less than a year. OK, an example might be accounts payable. My suppliers come in deliver a good or service, but I haven't paid them for it yet, which is nice. That's money sort of coming in because I've got the good or service, but I haven't paid them off for it yet. It's a payable. It's a liability. It's money that I owe to somebody, but it's kind of like trade credit to. It's kind of like free money that I've got coming in. OK. The current portion of debt that is due within a year is another current liability. Any increase in current liabilities is a source of cash. Think about the trade credit example I just gave. I've got the good or service, but I haven't actually delivered the cash that it represents yet. That's like a source of financing. So any increase or raise in current liabilities is money, is actual cash, coming into the firm. Similarly, any decrease in current liabilities is a cash drain. As I have to pay off those suppliers, the cash leaves the firm. Current liabilities goes down. That means cash leaving the firm. Again, these are balance sheet changes, and so they aren't reflected in net incomes or earnings. OK. On the flip side is current assets. That's stuff, assets, that I've sold, consumed, or exhausted in less than a year-- short term assets. Accounts receivable is a good example. That's money that I've given somebody a good or a service, my customers, but I haven't received the money yet. The real value, the economic product, is moved out of the firm. They've got the good or the surface, but they haven't delivered the money yet. That's a cash moving out of the firm. Another one is inventory. If I put money to buy inventory into the warehouse, it's just sitting there. I've spent the money to buy the inventory, but as it sits in the warehouse collecting dust, it's a cash outflow. But I haven't reflected it in sales yet because I haven't sold it. I haven't moved it out of the warehouse yet. Again, those are balance sheet changes, but they haven't been reflected in net income or earnings. We've got to go back and collect the cash. And that's what we're going to do. Any increase in current assets is a cash drain on the firm, stuff that I've shipped out that I haven't collected the cash for yet. The more I ship out but don't collect, the more of a cash drain that is on the firm. Similarly, any decrease in current assets is a source of cash. As I collect from my customers, that brings cash in. Current assets goes down. Cash comes in. OK. Let's walk through a really simple example. As I've got here a series of balance sheets for you laid out, where I've got current assets listed here for three years-- 100, 125, 135, 100. And I've got long term assets, which are just 150 the whole way through. Add those two together, and that gives me total assets of 250, 275, 285, and 250 for my three years. OK, on the other side of the balance sheet, I've got liabilities-- 75, 65, 65, and 100 of current liabilities, and then long term liabilities of 80 kind of the whole way through. Add those together for total liabilities. The balance sheet has to balance. So assets have to equal-- total current liabilities, long term liabilities, total liabilities, and total assets have to match once I add in equity. So the 250 has to equal 155 plus 95. The 275 has to equal 145 plus 130 for everything to add up. Now let's go through and compute working capital. In year 0, in my initial outlay, what's working capital going to be? Let's see. What are current assets? 100. What are current liabilities? 75. What's 100 minus 75? 25. OK, in the next year, current assets-- 125. Subtract current liabilities, 65. What's working capital? 60, 70, and then finally 100 minus 100 is 0. Now this line here gives me my working capital account. What creates the flow is the change in working capital because again, what creates the flow? The cash flow is money going into the wallet or coming out of the wallet-- not how much money is in the wallet, but the flow is what's going in or out. So to start up this project, what do I need? I need an initial inflow of working capital of 25. And there it is, 25. So the change in working capital is that initial investment. 25. Now what happens to working capital as I go from year 0 to year one. Working capital changes from 25 to 60. What does that mean? That means an increase in working capital of 35. That's an outflow of 35. Then working capital changes from 60 to 70. That creates an increase in working capital of 10. Yep, so that's an outflow of $10. What happens from year two to year three? Working capital decreases from 70 to 0. Maybe I'm settling all my accounts receivable and payables. Maybe I'm selling off everything else in the inventory, in the warehouse. That creates a change in working capital of minus 70. The minus change in working capital at the end is the money coming back out of the wallet into the firm. So again, it's changes in working capital that create the cash flow. Putting that back together with our free cash flow formula from the previous lesson, I take operating profit. I subtract any increase in working capital. Remember, an increase in working capital is a cash outflow. A decrease in working capital is a cash inflow. So to compute free cash flows, I want to subtract any increase in working capital. That gets tricky because it's a double change. Let's walk through it again. When I'm computing free cash flow, I want to subtract off any increase in working capital because an increase in working capital means a cash outflow from the firm. Good. And then, as we go through in the next lessons, we'll talk about depreciation, capital expenditures, and salvage values, put those together for a measure of free cash flow. OK, to wrap up-- working capital represents an opportunity cost. Increases in working capital are a real cash drain that are reflected on the balance sheet, but aren't reflected in measures of net income or accounting earnings. That means we've got to go back for our measure of free cash flow and mop up the differences in cash. Free cash flow needs to account for working capital changes.
