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 Domino's Pizza as of September, 2020, 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 property, plant, 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 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:
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.
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.
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.
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.
Accounts payable. Accounts payable are 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.
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: Domino's Pizza as of September, 2020
To calculate Domino's net working capital, we first need to obtain the seven data points described above from the company's historical SEC filings.
We have used these balance sheets to assemble a table that excerpts the current assets and current liabilities portion of Domino's balance sheet (below). We highlight those items that directly enter into a calculation of net working capital:
After entering this data into the Inputs worksheet of the "Online Tutorial 4.xlsx" 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:
The last step of the analysis calculates how much cash Domino's typically ties up in working capital to generate a dollar of new revenue.
How Do You Project Future Incremental Working Capital (%)?
In the case of Domino's, the company's relatively modest working capital needs leads us to anticipate that it won't be a major investment need. We project incremental working capital as a percentage of incremental sales to be approximately 15.0%, somewhat above the company's historical average.