Forecasting working capital, capex, cash flow and the balance sheet

How do you forecast working capital?

Apply a days ratio to the matching forecast flow. The working capital forecast turns three ratios and two income statement lines into three balance sheet accounts, so the balance sheet follows the income statement.

• Days sales outstanding (DSO) times revenue, divided by 365, gives receivables.
• Days of inventory times cost of sales, divided by 365, gives inventory.
• Days payable outstanding (DPO) times cost of sales, divided by 365, gives payables.

$$AR = \frac{DSO \times \text{Revenue}}{365}$$

$$Inv = \frac{DIO \times COGS}{365}, \quad AP = \frac{DPO \times COGS}{365}$$

Only receivables use revenue. Inventory and payables are measured at cost, so they use cost of sales. This is the most common slip in this lesson.

The exam can also give the balance and ask for the days, or give the days and the balance and ask for the flow behind it.

Net working capital is the sum of the operating lines. What matters for cash is its change.

$$NWC = AR + Inv - AP$$

Exam tip Receivables and inventory up means cash down. Payables up means cash up. Say it aloud before you pick the sign.

Go deeper Normalizing days after an unusual year

Days ratios drift when something unusual happens: a destocking year, a customer paying late, a supplier granting extended terms. Copying that year’s days into every forecast year bakes the one-off in. Analysts usually let the days move back toward the multi-year average over the forecast period, and say why. A spirits maker whose inventory days jumped after a sales slump, for example, would forecast the days falling as the extra stock is sold. That produces a cash inflow from working capital, which is worth stating because it flatters operating cash flow for a while.

How do you forecast capex and depreciation?

Forecast capex from the company’s plans, and depreciation from the asset base it creates. Capex is often a percentage of revenue, because capacity and sales move together. Depreciation can be a percentage of revenue, a percentage of opening property, plant, and equipment, or PP&E (the assets already in place), or a schedule asset by asset.

The capital expenditure forecast splits into two kinds of spending.

Capital expenditure

• Maintenance capex Use it keeps existing capacity running; roughly equals depreciation
• Growth capex Use it adds capacity; tied to volume plans; the part above depreciation

Maintenance capex keeps existing capacity running, so it roughly equals depreciation. Growth capex adds capacity and follows the volume plans. If capex persistently exceeds depreciation, the excess is growth spending and the asset base is expanding. The depreciation forecast then rises with the larger asset base.

PP&E follows the roll-forward rule: opening plus capex, minus depreciation, equals closing.

$$\text{Closing} = \text{Opening} + \text{additions} - \text{reductions}$$

How do the three forecast statements fit together?

Build the income statement first. Then net income, depreciation, the working capital change, capex and the financing plan give the pro forma cash flow statement . The pro forma balance sheet picks up every result, and it must balance.

Net income (from the income statement)

• Cash flow statement Use it built from the income statement and the plans
  • Operations net income + depreciation − increase in working capital
  • Investing − capex (± acquisitions and disposals)
  • Financing − dividends, − buybacks, ± debt
• Balance sheet Use it must balance every year
  • Working capital lines days × revenue or cost of sales
  • PP&E opening + capex − depreciation
  • Retained earnings opening + net income − dividends
  • Cash opening + net change in cash

Work through it in order:

1. Operations. Net income, plus depreciation (non-cash), minus the increase in net working capital.
2. Investing. Minus capex, plus or minus any acquisitions and disposals.
3. Financing. Minus dividends and buybacks, plus or minus new debt.
4. Balance sheet. Cash is opening cash plus the net change. Working capital lines come from the days. PP&E comes from the roll-forward, debt from the financing plan, and equity from the retained earnings roll-forward : opening plus net income, minus dividends.

$$CFO = NI + \text{depreciation} - \Delta NWC$$

Watch one assumption travel through all three statements in the model below. Change days sales outstanding and follow it from receivables to operating cash flow to cash.

The outputs of the model are the valuation model inputs : free cash flow to the firm and to equity, earnings per share (EPS), earnings before interest, taxes, depreciation, and amortization (EBITDA) and earnings before interest and taxes (EBIT). A discounted cash flow valuation takes the free cash flows, and multiples take EPS, EBITDA or EBIT.

Go deeper Why cash is the balancing item

In most models every balance sheet line has its own driver except cash. Cash is set last, from the cash flow statement, so the balance sheet balances by construction. If the forecast shows cash going negative, the company needs more financing than the plan includes. Larger models add a revolving credit line as the plug: it borrows when cash would fall below a minimum and repays when there is a surplus. That makes interest expense depend on the cash flow, which depends on interest, so the model becomes circular and is usually solved with an iteration switch or an average-balance shortcut.