What is Net Working Capital?
Net Working Capital and its direction are critical to understanding and valuing a business but receive too little attention. It’s also an essential part of how I calculate Owner Earnings. Let’s dive into Net Working Capital (NWC) first.
Net Working Capital = Current Assets (less cash) + Current Liabilities (less debt)
or
Net Working Capital = Accounts Receivable + Inventory - Accounts Payable
What is Net Working Capital?
NWC can measure a company’s liquidity and ability to meet short-term obligations like supplier payments. I personally use the second way to view NWC. By looking at NWC and its trends, we can see the company's leverage over its suppliers and customers. A declining NWC shows that a company can push its payments to suppliers (accounts payable) further into the future, receive payments quicker (accounts receivable) and delay increases in inventory stock. Ideally, a company can create enough leverage over its business partners and customers to let them pay for its growth: A company with negative Net Working Capital receives money before it delivers its service/item. This is a powerful tool and a competitive advantage that many large companies use.
Net Working Capital Changes
For my investment process, the change in NWC is more important than Net Working Capital. I predominantly look at Changes in Accounts Payable, Accounts Receivable, and Inventories. There are other factors, too, but these three are the most important ones. For SaaS businesses (or other subscription-based business models), changes in Unearned revenues can be significant as well.
Let’s look at the example of Napco Securities. Changes in NWC directly affect Cash from Operations, which is the basis for calculating Free Cash Flow or Owner Earnings.
Cash flow from Operations = Operating Income + Depreciation – Taxes + Change in Working Capital.
We can see that Changes in Accounts Payable ($3.64 million), Accounts Receivable (-$6.45 million) and inventories ($2.01 million) all significantly shift Cash from Operations ($42.3 million). These are temporary shifts in payment timing, which can highly distort the cash generation of a business. In Q3 22, Napco had Cash from Operations of just $1.6 million. However, inventory changes depressed cash flows by $27.65 million, and accounts payable and receivable had a positive $12.77 million tailwind combined. This happened because the chip shortage inflated inventory costs for a few quarters, making Napco look like a business with low cash generation.
Changes in NWC headwinds often revert to tailwinds, so I prefer to adjust them altogether. This leaves us with a steady state cash flow, part of my Owner Earnings formula:
By using steady-state cash flows, we have a more realistic picture of the business and can better evaluate without getting tricked by fluctuations in payment timings. However, Changes in NWC can also be a long-term trend as companies leverage their strength, as we established at the beginning of this article. Like everything in investing, Net Working Capital is a nuanced topic.
I hope this post has helped you understand this important aspect of fundamental analysis. To support me, consider subscribing to my blog or becoming a paid member. If you have a few minutes, please fill out the survey below to help improve Heavy Moat Investments.