Free Cash Flow to Firm and Net Change in [OPERATING] Working Capital

A few of my classmates have been asking me a very common question so I thought I would post the answer. Particularly because I think it is a fantastic question and is something I’ve wrestled with for sometime.

In Corporate Finance, Financial Management and Mergers & Acquisitions, one of the most important metrics of a company’s performance is it’s free cash flow. Or more specifically, it’s free cash flow to firm (aka. Unlevered free cash flow). This is the cash flow metric that is used to value the entire enterprise. It’s defined as:

FCFF = EBIT (1 – tax) + DA – NWC – Capex

Where:
EBIT is Earnings Before Interest and Tax (otherwise known as operating income)
DA is Depreciation and Amortization (which is actually a place holder for all non-cash expenses, but DA is the largest and most common one)
NWC – Change in net working capital (*NOTE* This is the tricky part that people are asking about)
Capex – Capital Expenditures

So while this formula is not new to most, what I want to focus on is NWC. If you have read my post on the difference between OPERATING working capital and working capital will know what I’m getting at.

First, before we even get to that, I want to emphasize a lesson taught in Anita McGahan’s first year strategy course relating to Dupont analysis (one of my favourite frameworks). Dupont analysis looks at Return on Equity and Anita made a fantastic point about how to look at the formula:

ROE = NI / Equity

ROE = (NI / A) * (A / E)

ROE = ROA * FLA

Where:
ROA is return on assets (Operational Strategy)
FLA is financial leverage (Financial Strategy)

In a discounted cash flow, a company’s value is calculated as it’s enterprise cash flows discounted at the appropriate enterprise cost of capital (it’s weighted average cost of capital).

In other words: In the summation formula, the numerator is operating (FCFF) and the denominator is financial (WACC).

This is another good way to think about the difference between OPERATING working capital (OWC) and working capital (WC) as I explained previously.

While the commonly accepted formula for FCFF is as explained above, anyone who has done a proper financial model is quick to learn that it isn’t change in net working capital which is important, but rather change in OPERATING net working capital (excluding financing items such as cash and short term debt).

FCFF = EBIT (1 – tax) + DA – NOWC - Capex

But the next logical question is what is the difference between something like short term debt (a quantifiable liability) and accounts payable (also a quantifiable liability which is equally a debt of sorts – a debt to a supplier). The answer? Interest.

The reason why something would be considered OPERATING working capital (or particularly an operating current liability) versus a normal working capital (or current liability) is that a financial current liability *bears interest* whereas an operating liability does not.

This raises the next interesting question: How do you treat pension liabilities? As you may recall, I mentioned previously how the CFA treat’s pensions as if they are interest bearing liabilities (or specifically, debts of the company owed to it’s workers which is expected to grow at the company’s cost of debt). This is a perfect example of a judgment call. Some of the top equity research analysts will consider pensions to be part of operating a business (not included in enterprise value as a financial consideration) whereas others will consider pensions to be a type of financing (don’t take my word for it, check out the research reports of companies with sizable pensions and see how different analysts treat different companies). Some will consider current pension obligations as debt (as it has to be financed to be paid out) whereas others will treat the entire long and short term obligation as debt.