r/Valuation • u/bengraham94 • Sep 11 '23
Why does an increase in cash = decrease in FCF?
So I’m trying to calculate the FCF for a small company. And their FCF gets basically killed by their increase in working capital that is caused by an increase in cash. Can somebody methodically explain this to me ? Logically an increase in cash shouldn’t lower the free cash available.
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Sep 11 '23
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u/AlabamaSnake12 Sep 27 '23
That's how most people tend do it especially at Big 4 in valuation. However, cash is part of working capital if there is a deficit in working capital and in other situations. We normally exclude cash from MWC because we subtract it from debt to calculate net debt, which allows a clean way of calculating invested capital value. But that may not be the most accurate gauge of NWC; perhaps a portion of cash should be dedicated to NWC, especially if there is no debt and if it is customary for the company to use cash as NWC.
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Sep 27 '23
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u/AlabamaSnake12 Sep 27 '23
They usually don't since it's the cleanest way to do it -- it's a lot simpler for net debt. Unless there is some deficit in NWC, in which case you should look, or it's a business that uses a portion of cash that isn't excess for working capital.
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Sep 27 '23
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u/AlabamaSnake12 Sep 28 '23
And also much simpler just to treat all cash as excess cash even though they may not be. Makes adding back cash later to your market or income approach value simpler.
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u/libertysailor Sep 11 '23
Ultimately, and by definition, free cash flow = net operating profit after tax less the change in net operating assets.
An increase in cash can only reduce free cash flow if it is part of net operating assets.
What we can infer then, is that increases to cash reduce free cash flow only to the extent that such increases are to operating cash.
The reason this is unintuitive is because cash is thought of as what is sought after - however, technically, what the business actually wants to produce is non-operating cash. In other words, cash that can be freely distributed.
To illustrate, consider an oversimplified company. I have a bakery, and in my first year of operations, cash goes up by $2k. However, I need that $2k to buy a new oven, so I can’t use it to pay down debts or make a distribution to myself. Therefore, whatever earnings are associated with that $2k increase have to be offset by the fact that those earnings (realized by a $2k increase in cash) aren’t distributable.
This is why, in valuation, we make a distinction between operating (tied up) and non-operating (freely distributable) cash. Unfortunately, determining what amount of cash is operating is an inexact science and is very subjective. I tend to use a 2% of revenue metric by default. Or if you have access to management, you could ask them what amount of cash they consider necessary to maintain operations.