The Complete Guide to Changes in Working Capital and Owner EarningsWritten by

Jae Jun

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Read this page slowly, and download the worksheet at the bottom of the post, because the whole topic of changes in working capital is very confusing.

Getting Back to the Basics of “Change” in Working Capital

If you just want the definition of working capital, it’s simply

But what you really need to know about working capital is how and why it matters. That’s where the “change” comes into play.

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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 useful tool? Warren and I routinely do this, but most 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.

It’s taken a lot of thought over many years to full understand this idea of what the “change” in changes in working capital actually means and how it should be applied to valuation and financial analysis.

Here’s another quote from Munger before I dive into things as it sums up this topic well.

First, working capital is NOT the same as the change in working capital.

current assets – current liabilities.

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 explanations are referring to.

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 point in time.

Operating Working Capital or Non Cash Working Capital

One line that I like from the Wikipedia definition is this:

What this also means is that when talking about working capital needs, you need to break it down to consider the operating aspects only.

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

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 change part really means, how to interpret and use it when analyzing and valuing companies.

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 makes no sense to constantly check whether you have more assets than liabilities on the balance sheet.

companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretching accounts payable.

Note the emphasis on the word cycle. It’s not talking about a value from a single point in time. It’s referring to the entire cycle that businesses constantly try to shorten.

Just like how capital expenditures can be broken down between growth capex and maintenance capex, working capital has to be broken down to “operating working capital”.

Another name for this is non cash working capital, because current assets includes cash, which is not used to operate the business and has to be taken out.

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 School Value Analyzer.

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

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

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 stretching accounts payable.

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.

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.

Increasing any of these requires the use of cash.

Increasing any of these requires delaying the use of cash.

What the CHANGE Really Stands For

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 number.

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 or getting money upfront before the service is provided.

Put another way, if changes in working capital is negative, the company needs more capital to grow, and therefore working capital (not the “change”) is actually increasing.

If change in working capital is positive, the company can grow with less capital because it is delaying payments or getting the money upfront. Therefore working 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.

= Previous Working Capital – New Working Capital

Change in Working Capital Examples

Let’s compare the changes in working capital between Microsoft and Apple, and then Wal-Mart and Amazon.

Change in Working Capital is a cash flow item and it is always better and easier to use the numbers from the cash flow statement as I showed above in the screenshot.

The “change” refers to how the cash flow has changed based on the working capital changes. You have to think link what happens to cash flow when an asset or liability increases.

To tie this together, the “change” is about determining whether current operating assets or current operating liabilities is increasing.

If the final value for Change in Working Capital is negative, that means that the change in the current operating assets has increased higher than the current operating liabilities.

If Changes in Working Capital is positive, the change in current operating liabilities has increased more than the current assets part.

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 how you do it and how the data from the OSV Analyzer is provided.

Changes in 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)

Without showing you the numbers first, my initial guess is that because Microsoft is mainly a software business, their change in working capital should be 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. Or even if it is positive, should require more capital than Microsoft to grow.

Microsoft Changes in Working Capital | Enlarge

While there aren’t any red flags or signs of constant working capital needs by Microsoft, it’s not as good as I initially thought it would be.Compare this with Apple.

Apple Changes in Working Capital | Enlarge

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.

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 increasing inventory. In 2015, Microsoft used more muscle to extend payments to reduce the capital needed to grow. The TTM number is lower than 2015 due to an increase in inventory and lower account payables (being a good customer).

A totally different story where change in working capital is consistently positive. Current operating liabilities has increased more than the operating assets each year.

Better value than Microsoft too.

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. Previously, Wal-Mart kept having to pay for inventory faster than it was paying its bills.

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

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

It needed a lot more cash to keep growing. However, the big shift in 2015 is due to the huge leap in accounts payable resulting in positive change in working capital.

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

Using Change in Working Capital to Calculate Warren Buffett’s Owner Earnings

The whole point of understanding changes in working capital is to know how to apply it to your cash flow calculation when doing a DCF.

Here’s how I interpreted it previously.

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.

(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.

It’s also a case by case basis.

Here’s the simple version.

Over the past few years, Amazon is spending even more on inventory than Wal-Mart. Their accounts payables is consistent, but the deferred revenue is the awesome part. The rate at which they are 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 improve and focus on their e-commerce business, their numbers should shift to look more like Amazon going forward.

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 honestly made things even more confusing.

If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.) – 1986 Berkshire letter

Buffett also mentions “additional working capital” in the paragraph. He says that additional working capital “should be included in (c)”. This means that on any given year where additional working capital is required to maintain the business, it should be included in capex. Otherwise, the rest of working capital should be excluded from owner earnings.

If you went through everything in this article up to this point to truly understand what the CHANGE means, Buffett is simply talking about the importance of cash flows due to working capital.

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

Again, Buffett isn’t going into the specifics of whether to add or subtract the number. He is saying that you should think about how the cash flow requirements of the business is to affect the final owner earnings calculation.

My problem was that I was looking at the numbers too much without seeing the entire picture of cash flow. This led me to my mistakes in the calculations.

However, when you look and think about each component and simplify it to the two points above, it makes the entire calculation that much easier.

The overall owner earnings formula is still accurate.

Owner Earnings =

If the change in working capital is negative, that means working capital increased as the company needs more capital to grow. This reduces cash 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 has more cash for the company to grow and play with. This increases cash flow and so it should added to owner earnings. (included in this case)

(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.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.) – Buffett

Microsoft Owner Earnings Example

Numbers and formatting is from Old School Value, follow along if you a member. You can get these numbers from the SEC filings too and follow the examples.

Microsoft Owner Earnings | Click to Enlarge

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

Therefore, Microsoft’s TTM owner earnings comes out to be:

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

i.e. don’t do – -1,471 because it comes back to my error of focusing too much on the numbers and signs.

Using the TTM figures in millions:

Because changes in working capital is negative, it should reduce FCF because it means working capital has increased and decreases cash flow.

12,273+5,990+2,598-6,018 - 1,471 = 13,372

12,273+5,990+2,598-6,018 + -1,471 = 13,372

The goal is to

1. calculate the change in working capital

3. add or subtract the amount

I’m going to show 5 years of results for Amazon to show the hidden strength of what changes in working capital can reveal when used with owner earnings.

That’s why the formula is written as +/- changes in working capital.

2. determine whether the cash flow will increase or decrease based on the needs of the business

Amazon Owner Earnings Example

Amazon Owner Earnings Shows Underlying Strength of Company | Enlarge

Using the TTM figures in millions:Net income = $328D&A = $5,909Other non cash charges = $2,001Capex = $4,424Changes in working capital = $6,422

And because of the strength in their business model, the owner earnings greatly outpaces the standard FCF calculation.

For most companies you analyze, by using the change in working capital in this way, the FCF calculation and owner earnings calculation is similar.

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

Rules of Thumb and Summary

If an asset increases:

change in working capital is negative

actual working capital increases

cash flow is reduced

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 change in working capital

References

Unlike Microsoft or Wal-Mart, Amazon changes in working capital is positive. It is added to the owner earnings as the company needs less capital to grow and so it will increase cash flow.

Owner Earnings = 328 + 5909 + 2001 – 4424 + 6422 = 10,236

The fundamental purpose of even discussing working capital is about cash flow needs of a business. Not the balance sheet calculation.

subtract the change from cash flows for owner earnings

FCF calculation example using changes in working capitalyoutube videoDCF calculation with change in working capital explanationProf Damodaran on non cash working capital

Microsoft Corporation (MSFT)

Annual Statements ($ in millions) 2011 2012 Change in Accounts Receivable $ (1,451.0) $ (1,156.0) Change in Inventories $ (561.0) $ 184.0 Change in Prepaid Expenses $ - $ - Change in Other Current Assets $ (1,259.0) $ 493.0

Change in Current Assets $ (3,271.0) $ (479.0)

Change in Accounts Payable & Accrued Expenses $ 58.0 $ (31.0) Change in Deferred Revenue $ - $ - Change in Income Taxes Payable $ - $ - Change in Other Current Liabilities $ (1,146.0) $ 410.0

Change in Current Liabilities $ (1,088.0) $ 379.0

Change in Working Capital $ (4,359.0) $ (100.0)

Wal-Mart Stores (WMT)

Annual Statements ($ in millions) 2011 2012 Change in Accounts Receivable $ - $ - Change in Inventories $ (3,205.0) $ (3,727.0) Change in Prepaid Expenses $ - $ - Change in Other Current Assets $ (733.0) $ (796.0)Change in Current Assets $ (3,938.0) $ (4,523.0)

Change in Accounts Payable & Accrued Expenses $ 2,396.0 $ 1,752.0 Change in Deferred Revenue $ - $ - Change in Income Taxes Payable $ (153.0) $ 994.0 Change in Other Current Liabilities $ - $ - Change in Current Liabilities $ 2,243.0 $ 2,746.0

Change in Working Capital $ (1,695.0) $ (1,777.0)

2013 2014 2015 TTM $ (1,807.0) $ (1,120.0) $ 1,456.0 $ 1,205.0 $ (802.0) $ (161.0) $ (272.0) $ (726.0) $ - $ - $ - $ - $ (129.0) $ (29.0) $ 62.0 $ 62.0

$ (2,738.0) $ (1,310.0) $ 1,246.0 $ 541.0

$ 537.0 $ 473.0 $ (1,054.0) $ (530.0) $ - $ - $ - $ - $ - $ - $ - $ - $ 146.0 $ 1,075.0 $ (624.0) $ (1,482.0)

$ 683.0 $ 1,548.0 $ (1,678.0) $ (2,012.0)

$ (2,055.0) $ 238.0 $ (432.0) $ (1,471.0)

2013 2014 2015 TTM $ - $ - $ - $ - $ (2,759.0) $ (1,667.0) $ (1,229.0) $ (1,053.0) $ - $ - $ - $ - $ (614.0) $ (566.0) $ (569.0) $ (590.0) $ (3,373.0) $ (2,233.0) $ (1,798.0) $ (1,643.0)

$ 1,332.0 $ 634.0 $ 3,927.0 $ 3,521.0 $ - $ - $ - $ - $ 981.0 $ (1,224.0) $ 166.0 $ (20.0) $ - $ - $ - $ - $ 2,313.0 $ (590.0) $ 4,093.0 $ 3,501.0

$ (1,060.0) $ (2,823.0) $ 2,295.0 $ 1,858.0

Apple Inc (AAPL)

Annual Statements ($ in millions) 2010 2011 2012 Change in Accounts Receivable $ 143.0 $ (5,551.0) $ (2,172.0) Change in Inventories $ 275.0 $ (15.0) $ (973.0) Change in Prepaid Expenses $ - $ - $ - Change in Other Current Assets $ (1,934.0) $ (1,414.0) $ 223.0

Change in Current Assets $ (1,516.0) $ (6,980.0) $ (2,922.0)

Change in Accounts Payable & Accrued Expenses $ 2,515.0 $ 4,467.0 $ 2,340.0 Change in Deferred Revenue $ 1,654.0 $ 2,824.0 $ 1,459.0 Change in Income Taxes Payable $ - $ - $ - Change in Other Current Liabilities $ - $ - $ -

Change in Current Liabilities $ 4,169.0 $ 7,291.0 $ 3,799.0

Change in Working Capital $ 2,653.0 $ 311.0 $ 877.0

Amazon.com (AMZN)

Annual Statements ($ in millions) 2010 2011 2012 Change in Accounts Receivable $ (295.0) $ (866.0) $ (861.0) Change in Inventories $ (1,019.0) $ (1,777.0) $ (999.0) Change in Prepaid Expenses $ - $ - $ - Change in Other Current Assets $ - $ - $ - Change in Current Assets $ (1,314.0) $ (2,643.0) $ (1,860.0)

Change in Accounts Payable & Accrued Expenses $ 3,113.0 $ 4,064.0 $ 3,108.0 Change in Deferred Revenue $ 687.0 $ 1,064.0 $ 1,796.0 Change in Income Taxes Payable $ - $ - $ - Change in Other Current Liabilities $ - $ - $ - Change in Current Liabilities $ 3,800.0 $ 5,128.0 $ 4,904.0

Change in Working Capital $ 2,486.0 $ 2,485.0 $ 3,044.0

2013 2014 TTM $ (4,232.0) $ 611.0 $ 611.0 $ (76.0) $ (238.0) $ (238.0) $ - $ - $ - $ (2,220.0) $ (3,735.0) $ (3,735.0)

$ (6,528.0) $ (3,362.0) $ (3,362.0)

$ 5,938.0 $ 5,400.0 $ 5,400.0 $ 1,460.0 $ 1,042.0 $ 1,042.0 $ - $ - $ - $ - $ - $ -

$ 7,398.0 $ 6,442.0 $ 6,442.0

$ 870.0 $ 3,080.0 $ 3,080.0

2013 2014 TTM $ (846.0) $ (1,039.0) $ (1,682.0) $ (1,410.0) $ (1,193.0) $ (1,982.0) $ - $ - $ - $ - $ - $ - $ (2,256.0) $ (2,232.0) $ (3,664.0)

$ 2,624.0 $ 2,465.0 $ 3,729.0 $ 2,691.0 $ 4,433.0 $ 6,357.0 $ - $ - $ - $ - $ - $ - $ 5,315.0 $ 6,898.0 $ 10,086.0

$ 3,059.0 $ 4,666.0 $ 6,422.0