Author Topic: Changes in operating assets and liabilities:  (Read 6341 times)

scorpioncapital

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Changes in operating assets and liabilities:
« on: February 02, 2018, 01:57:51 AM »
I have looked at many a cash flow statement , more generally to determine free cash flow generation.

I am often stymied by the "Changes in operating assets and liabilities:" line that appears within operating cash-flows. Can these safely be ignored?

For example, I just use the net income, backout any charges other than these operating asset/liability movements and deduct certain capital expenditures...



Cigarbutt

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Re: Changes in operating assets and liabilities:
« Reply #1 on: February 02, 2018, 06:23:26 AM »
Few comments about working capital and the impact on CFO.

-There is an inherent bias to improve the cash flow position and so to "take advantage" of working capital end of period adjustments but I think that these adjustments are likely minor in most cases and are inconsequential in the long term.
-In a typical business (more complicated if many different subs), the ratio of working capital to assets should remain relatively constant. What I look for is a tendency for small but incremental decrease in this ratio or a rapid regression to the mean after an acquisition or major expansion. An argument could be made that relentless improvements in accounts receivables and inventory mangement can contribute to the free cash flow number over time. Not many firms can achieve this.
-Otherwise, unless there are liquidity/distress issues, I just remove the non-cash working capital adjustment in order to estimate free cash flow. I have also used a three year rolling average.

The challenge is more with "certain capital expenditures". Disclosure, even in the MD&A, does not usually, allow a precise estimation of free cash flow after "maintenance" capex. Dissection of the depreciation expense vs fixed assets vs capex over time can be helpful. I find that firms that report free cash flow measures tend to be optimistic. 

scorpioncapital

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Re: Changes in operating assets and liabilities:
« Reply #2 on: February 02, 2018, 08:49:54 AM »
That's very interesting. It sounds like there are various flavours of capex, depreciation and amortization. Some are more desirable than others. Just wondering what some differences would be. Amortization I remember Buffett saying was more likely not to be a real expense but in fact the asset could be worth more than purchase price , much less a depreciated sum. An example  - some countries allow depreciation of domain names. I guess maintenance capex is less desirable than growth capex, unless the capex results in no growth!

Cigarbutt

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Re: Changes in operating assets and liabilities:
« Reply #3 on: February 02, 2018, 10:28:56 AM »
Evaluating the amortization of defined-life intangibles can be tricky. It can go both ways.

Going to the initial transaction that gave rise to the intangible recognition and following up on profitability can help but acquired operations are often melted into something else. It may take a while before trends appear.

I don't see aggressive amortization of intangible value as a serious problem because the earning power should eventually be recognized in retained earnings. I much prefer too rapid amortization to the sudden realization that a massive write-down is necessary. A point can be made that well established pattern of excessive amortization could result in an upward adjustment to the free cash flow estimate.

There is one non-cash cash flow item that I often stumble upon: the amortization of share-base expense and its tax implication. It is clear that the item does not affect present free cah flow but it clearly affects the free cash flow per share down the line. Many ways to deal with this. Instead of trying to estimate eventual share dilution, I tend not to add it back. This "looks like a free lunch" item can be particularly costly over time if the hard earned cash of the firm is used after to buy back overvalued shares.

scorpioncapital

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Re: Changes in operating assets and liabilities:
« Reply #4 on: February 03, 2018, 01:34:07 AM »
If I add back the share based compensation, I will use the fully diluted share count including RSUs and stock options. If I don't add back the compensation, I will use the share count without these items.

compoundvalue

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Re: Changes in operating assets and liabilities:
« Reply #5 on: February 04, 2018, 05:10:38 AM »
Changes in operating assets and liabilities also relate to capital efficiency:
- A business with low levels of net working capital (as a % of revenue) is more capital efficient compared with a business with higher levels of net WC. It would require less capital to grow
- A business with negative working capital (e.g. retail) generates cash from WC when it grows. This is a huge plus at times of expansion
The above reverses if the business contracts: the positive WC business generates cash flow while the negative WC business requires CF (paying to suppliers for past purchases higher sums than what's being collected from customers on a smaller revenue base).
All told I think it's safe to say that a business with low levels of net WC is better than a business with high levels of net WC. A business with negative WC is even better, it uses WC as a source of capital to fund growth (a retailer charges customers in cash and gets credit from suppliers, the delta can be used to buy inventory, for Capex etc.)
The above affects ROIC which should affect the multiple (businesses with higher ROICs should generally be assigned higher multiples)
« Last Edit: February 04, 2018, 05:13:38 AM by compoundvalue »

scorpioncapital

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Re: Changes in operating assets and liabilities:
« Reply #6 on: February 04, 2018, 06:18:52 AM »
When we say positive net working capital, it means the line "Changes in Working Capital" is a positive number vs negative? I've seen companies swinging from positive to negative based on the year, so over time I guess you can net it out. When we say a low % of net working capital to revenues, is there a figure that is considered pretty good or kind of high?

compoundvalue

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Re: Changes in operating assets and liabilities:
« Reply #7 on: February 04, 2018, 07:12:42 AM »
NWC should be calculated from the balance sheet. Generally speaking:
Inventory + Accounts Receivable + Other Operating Assets - Accounts Payable - Other Operating Liabilities = NWC
Please note that the Other Assets/Liabilities part varies between companies. Each asset/liability in the balance sheet should be examined in order to determine whether it's an operating asset/liability.
The "Changes in WC" line in the cash flow statement represent the delta between balance sheet dates. For example:
-NWC 12/31/2016 USD100m
-NWC 12/31/2017 USD120m
2017 Changes in WC in the cash flow statement: ($20m) or negative cash flow of USD20m
No good figure for NWC as a % of revenue, generally speaking the lower the better. Having said that, when liquidation value is concerned negative NWC is a bad thing. All of the above refers to a going (and growing) concern situation.

For further reading I highly recommend the McKinsey valuation book

KJP

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Re: Changes in operating assets and liabilities:
« Reply #8 on: February 04, 2018, 07:24:14 AM »
When we say positive net working capital, it means the line "Changes in Working Capital" is a positive number vs negative? I've seen companies swinging from positive to negative based on the year, so over time I guess you can net it out. When we say a low % of net working capital to revenues, is there a figure that is considered pretty good or kind of high?

A "positive net working capital" business model means that the business needs more working capital (e.g., inventory or accounts receivable) as it grows.  Think of a typical retailer -- as it opens more stores, it has to stock each one, leading to more overall inventory on the balance sheet.  Therefore, as this type of business grows, the "changes in working capital" line on the cash flow statement will be negative, because a portion of net earnings is being reinvested in additional working capital, rather than converted into cash that can be distributed to shareholders.  When this type of business contracts, it should free up working capital as inventory is converted to cash and not replaced with new inventory, resulting in the "changes in working capital" line to be positive.  The ultimate example of this being a liquidation in which the business is closed and all working capital converted to cash.

A "negative net working capital" business model has the opposite characteristics.  For a current example, look at the 2016 and 2015 balance sheets of Wayfair and its 2016 cash flow statement.  Then ask yourself what would those financial statements look like if Wayfair's sales started to decline, rather than rapidly increase.
« Last Edit: February 05, 2018, 07:04:18 AM by KJP »

Cigarbutt

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Re: Changes in operating assets and liabilities:
« Reply #9 on: February 04, 2018, 05:55:05 PM »
Interesting case of a firm that went from a positive working capital balance in the direction of a negative one is Dell in the 1990's. The cash conversion cycle went from 50 days in 1994 to minus 43 days in 2004. (!)
This was achieved through improvements in AR receivables management to some degree but mostly through significant improvements in inventory management and stretching of AP.
This provided no cost financing at a time of growth and improved return on capital.
However, for Dell, at some point, maximum improvement was reached. When close to privatization, the cash conversion cycle was minus 41 days.

Concerning Wayfair, I haven't looked into details but their model is interesting. They invest a lot in publicity and marketing and I wonder if the return on that will, in the end, be more profitable than the traditional brick and mortar furniture store model. I would say that these days, tight working capital management may not be top priority if growth-hungry cheap capital is ready to fund your venture. That may change. I still like to sit on the sofa or test the mattress before I buy it. Maybe Millenials will change that. :)

 
« Last Edit: February 04, 2018, 05:57:12 PM by Cigarbutt »