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In calculating Working capital for valuation purposes text books focus on current liabilities (net of cash) and Current liabilities ( all non-interest earning debt, but including Supplier credit, accounts payable and accrued items (salaries, taxes etc)).
For me at least, it makes sense to measure changes inventories because it represents cash tied up-within firm that may be crucial to its operations (almost like a form of capex especially for the retail sector). Moreover, the value of inventories may appreciate representing an asset gain or conversely depreciate, or never be utilized in sales (in which case would constitute an expense). All of which would affect the value of the firm
However (and my question is) why are changes in receivables and payables included in free cash flow ?
Effectively a Receivable is an interest free loan to made to the customer while a payable is more or less credit extension by a company’s suppliers. In the case of receivables I view them as earnings in transit, where the cash here is actually rightfully owned by the firm. In the case of Payables I see this as largely interest free borrowings but more importantly cash that is not owned by the firm.
It is my observation that increase in accounts payable overstate FCF and increases in accounts receivables understate FCF.
If I were looking at this from a credit or liquidity perspective – factoring both makes sense.
However, if I am looking at this from an Owner Earnings Perspective, then changes in payables and receivables I believe distort the value of the firm.
This is the impression I have received from reading Berkshire Hathaway’s 1986 Chairman’s letter to Shareholders. Where Warren Buffett purposes:
Owner earnings = Net income + depreciation & amortization +/- one-time items - capital expenditures Read More