Module 3: Working Capital, Capital Expenditure, and Cash Conversion
Learning objectives and prerequisites
By the end of this lesson, you should be able to translate operating growth into working-capital and asset investment. Prerequisite knowledge: Modules 1–2 and balance-sheet timing accounts. Work from assumptions to equations, explain the acquisition consequence, and record the evidence needed to rely on the answer.
Units: $000 unless a section explicitly states otherwise.
Learning objectives: Forecast operating NWC, distinguish maintenance from growth investment, and reconcile earnings to UFCF. Study time: 2 hours.
Working capital represents financing supplied by the business
A profitable job can consume cash before collection. Accounts receivable represent earned revenue awaiting payment; inventory represents purchases awaiting use or sale. Accounts payable and operating accruals provide temporary supplier and employee financing. Customer deposits may finance operations but also create future delivery obligations. Keep them visible rather than treating deposits as free cash.
Use average balances for historical turnover where available. For forecast ending balances, apply an explicit convention consistently:
Receivables = annual revenue / 365 × DSO
Inventory = annual cost of sales / 365 × DIO
Payables = annual cost of sales / 365 × DPO
Operating NWC = receivables + inventory - payables
Cash investment in NWC = ending NWC - beginning NWC
DSO means days sales outstanding; DIO means days inventory outstanding; DPO means days payable outstanding. A detailed model may use purchases rather than cost of sales for payables and monthly seasonality rather than annual averages. Include other operating balances when material. Do not mix an abbreviated forecast with a broader historical definition without a reconciliation.
Worked cash conversion example
Harbor forecasts revenue of 5,200 and cost of sales of 3,120. At DSO 40, DIO 20, and DPO 30:
| Balance | Calculation | Forecast |
|---|---|---|
| Receivables | 5,200 / 365 × 40 | 569.9 |
| Inventory | 3,120 / 365 × 20 | 171.0 |
| Payables | 3,120 / 365 × 30 | 256.4 |
| Operating NWC | Receivables + inventory - payables | 484.4 |
If beginning NWC is 440, the business invests 44.4. With NOPAT 550, D&A 100, and CapEx 140, UFCF equals 465.6. If DSO worsens to 50, receivables rise another 142.5 and UFCF falls to about 323.2. EBITDA has not changed. Collection performance can therefore determine whether a leveraged acquisition survives.
Capital spending requires an asset schedule
Maintenance CapEx preserves current earning capacity; growth CapEx supports additional capacity. The distinction affects interpretation, but both are cash outflows in UFCF. Request fixed-asset registers, vehicle age, repair logs, replacement quotes, lease schedules, and planned expansion. Low historical CapEx can signal deferred replacement rather than an efficient business.
Create an asset schedule by equipment category: opening gross assets, additions, disposals, accumulated depreciation, and closing net book value. Book depreciation is not a reliable proxy for future replacement cost. Tax depreciation can be accelerated and should not determine maintenance spending automatically. Model disposal proceeds and gains separately when material so proceeds are not counted twice.
A stable terminal business still needs reinvestment. Setting CapEx to zero while maintaining perpetual growth is generally inconsistent with an equipment-dependent operation. Growth may also require a larger receivables balance even if collection days stay constant.
Practice and answer key
Sales are 3,650, cost of sales 2,190, DSO 30, DIO 15, and DPO 20. Beginning NWC is 250. NOPAT is 400, D&A 60, and CapEx 90.
Solution moved to the separate instructor key.
Deliverable: An NWC schedule and replacement plan with a 10-day DSO sensitivity. Explain how much of forecast cash conversion comes from genuine earnings and how much comes from temporary balance-sheet movements.
Working-capital changes describe a stock-to-flow relationship
A balance sheet records the stock of operating investment at a date, while the cash-flow statement measures the year's change. Harbor's receivables are a use of capital even if the invoices are fully collectible: someone must fund the period between service and payment. Subtracting all ending receivables every year would charge the business repeatedly for the same opening investment.
Reconcile both beginning and ending NWC under the same account definition. If the forecast includes only receivables, inventory and payables, do not compare it with a historical number that also includes payroll accruals and customer deposits without a bridge. A seemingly small definitional change can make projected cash conversion look much better than it is.
Collection timing can defeat an annual model
At 5,200 annual sales, ten more collection days absorb 5,200 / 365 × 10 = 142.4658. That is approximately 142,466 actual dollars under this lesson's $000 convention. The income statement does not change if revenue was properly earned and remains collectible, but operating cash falls. A price discount does not itself accelerate the customer's payment.
An annual DSO assumption is a simplification. If summer work accounts for much of revenue, month-end receivables and payroll can peak before cash arrives. Build a monthly collections schedule from invoice dates and expected settlement. Include an explicit minimum-cash requirement and the availability of any committed facility. Do not use an assumed revolver as a plug that silently grows whenever cash becomes negative.
Distinguish a reserve correction from new cash spending
If inventory includes 20 of obsolete parts, the accounting correction reduces stock and earnings, but no new cash is paid when the loss is recognized. The cash may have left when those parts were purchased. Using net inventory in the working-capital bridge can reverse the noncash charge's effect; adding the charge back separately as well can double count the reversal. Choose a consistent gross or net approach and document it.
The purchase-price mechanism is another layer. A stock shortfall can reduce consideration under an agreed peg, while the buyer still needs to restore usable parts. If the seller pays 20 less consideration and the buyer invests 20 to restore operations, total funding may be unchanged. Value allocation and operational liquidity are different questions.
Maintenance CapEx is an engineering estimate
A fleet's book depreciation reflects allocated historical cost. Future replacement depends on condition, service use, residual values, inflation and capacity needs. Request an asset list with age, maintenance history, ownership, liens and quotes. A van that is fully depreciated can still operate, but a forecast that assumes no replacement for a worn fleet is not conservative merely because it follows the books.
Construct a category roll-forward of gross assets, additions, disposals and accumulated depreciation. For teaching, a 100 asset depreciated straight-line over five years with no residual produces 20 annual depreciation. Buying it at midyear can produce 10 in the first year under a half-year convention, but cash CapEx is still 100 when paid. Identify which timing convention is used; tax deductions may follow different rules.
Sustainable growth requires a reinvestment explanation
A business can temporarily grow using spare capacity, but cannot expand forever without supporting people, equipment or working capital. In the terminal year, rebuild sales, operating margin, depreciation, CapEx and incremental NWC at the long-run growth rate. Growing an already distorted cash number mechanically can preserve an explicit-period timing error forever.
The spreadsheet lab should test both a collections delay and a replacement acceleration. Separate a temporary 50 fleet catch-up from recurring maintenance of 120. Show their different effects on Year 1 cash and terminal value. A well-supported acquisition recommendation might accept a fair operating price while requiring additional equity to fund that first-year catch-up.
Spreadsheet construction and audit lab
Forecast AR, inventory and AP from days assumptions. Link beginning balances to the previous period, calculate changes and feed cash flow. Build a separate PP&E roll-forward so replacement needs cannot disappear through an EBITDA add-back.
Use named row labels and explicit units. Blue-font inputs should contain assumptions or source data; black-font formulas should calculate results from those inputs. Reproduce the worked example first, then change one economically important assumption and predict the direction of the result before recalculating. Save a base case and a dated challenge case rather than silently replacing assumptions. A zero arithmetic check does not establish an executable deal.
Learning summary and further reading
Translate operating growth into working-capital and asset investment. The acquisition decision depends on the bridge between source evidence, modeled cash and the claim being valued. Explain what the model includes, what it omits, and which outstanding evidence could reverse your conclusion. Consult the source and alignment references for attributed public reading; fictional case assumptions are not market observations or legal approvals.
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Independent assessment
Complete the student assignment before consulting the separate instructor key. The chapter's worked examples teach the method; the assignment uses independent inputs.