Understand the difference between net working capital and capital expenditures. Then, calculate net working capital.
- [Instructor] Net working capital, or NWC, is the cash that Richards has tied up in day-to-day operations. As the company grows, it'll need more and more cash, that's obvious. For example, you may need to invest a bit more in marketing, or provide more services, maybe set up a website, or you many need to increase your inventory. A number of things may be required that need financing. The NWC is the cash that's dedicated to that part of the business. In its most basic form, it's used to measure the short-term liquidity of the business. It's equivalent to current assets minus current liabilities.
We don't use cash in this calculation. An increase in current assets represents an investment of cash which decreases available funds. Analogously, a decrease in current liabilities represents a use of cash, which also decreases available funds. Decreases in current assets and increases in current liabilities increase available funds. Let's look at the equation again. I'll go ahead and finish bolding it out so that we know that we've covered all the steps. Notice how the equation is delta NWC.
That means we're going to be observing the change in net working capital from one year to the next. I'm in the 04_04_Begin exercise file. Let's go ahead and calculate the change in net working capital. We'll need current assets and current liabilities. The current assets for us are accounts receivable and inventory. Remember, we're not using cash in this calculation. So we'll be using rows 19 and 20. Let me go and highlight those so it's easier to see. The current liabilities are accounts payable, wages payable, taxes payable, short-term notes, and current part of long-term debt.
That's rows 25 through 29. So let me highlight those. And I'll change the color on that so these are also easy to find. So let me create another label. In A-42, I'll create a label called delta NWC. Since I don't have any values from 2016, my change in NWC is just going to be zero. I can't assume that my change in net working capital is current assets minus current liabilities for the year 2017, so I'm just going to make that zero.
For my projected 2018 value, I'll have to subtract 2018's NWC by 2017's NWC. You can do that directly by using the sum function four times. So remember, it's current assets minus current liabilities. So to calculate change in net working capital for 2018, I'll type in an equal sign and the first thing I'm going to do is find the sum of my assets for 2018. I'm going to subtract that from the sum of my liabilities for 2018, and then that's going to be subtracted from the sum of my assets from 2017 minus the sum of my liabilities from 2017.
Now I'm going to do the same kind of calculation for 2019 and 2020, but I'm just going to change the values around. Once I'm all done with this, it looks like I have some negative net working capital, hmm. The biggest hit that we take is between 2018 and 2017. Of course, that makes sense 'cause we're investing in PP and E. It's not the worst thing in the world. Don't worry about it. It's okay to have a negative delta NWC.
Richards is not about to go under or lose investors. All that a negative working capital position tells you is that more cash has gone out than come in, and that's okay. Let's see what the free cash flows look like. So I'm going to create another label and this is going to be our free cash flows and it's going to be in cell A-43. Remember that we can calculate free cash flows by using EBIAT plus depreciation minus CAPEX minus delta NWC. So let's go and do that. So in cell B-43, I'm going to set that equal to EBIAT plus a depreciation that we need to add back, minus capital expenses, minus delta NWC.
Great, so we have a free cash flow about $350,000, that's pretty good. So I'm going to do the same thing for the rest of the years and see what I get. Well, it looks like we have some positive cash flows coming in year after year, that's great news. A positive free cash flow is a good indicator or Richards' performance and where we expect to go in the future. A lot of investors are really going to like this report.
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