style="font-size:15px;"> [1-35]
Equation [1-34] defines the impact EBITDA, Depreciation and Amortization, Taxes, and Capital Employed have on the Return on Capital Employed. Managers have the ability to impact all of these variables. As mentioned earlier, tax minimization is best handled by getting good advice. Depreciation and Amortization is the price paid for making investments to drive Revenue, EBIT, and ultimately Net Income. The amount of Capital Employed is a consequence of the capital structure (combination of debt and equity) and how well management manages the company's balance sheet. Equation [1-35] clearly spells out how important it is for management to do its homework up front, select the best investment opportunities, and aggressively manage them and the balance sheet if they are to deliver returns in line with expectations.
Now that the groundwork for understanding the drivers of the Return on Capital Employed has been laid, it's appropriate to turn attention to cash flow and what drives it. However, before that is done another kind of capital needs to be discussed.
Working Capital
Working Capital (WC) is defined as
[1-36]WC = Current Assets − Current Liabilities
It is the Capital that the Company works with on a daily basis to produce its deliverable, collect money, and pay its bills. Equation [1-22] defines Current Assets as consisting of Cash, Accounts Receivable (AR), and Inventory (Inv):
[1-22]Current Assets = Cash + Accounts Receivable + Inventory
or
[1-37]CA = Cash + AR + Inv
Similarly, Equation [1-26] defines Current Liabilities as consisting of Accounts Payable (AP), Taxes Payable (TP), and Short-Term Debt (STD):
[1-26]Current Liabilities = Accounts Payable + Taxes Payable
+ Short-Term Debt
or
[1-38]CL = AP + TP + STD
Substituting Equations [1-37] and [1-38] in Equation [1-36] creates an expression for WC in terms of its Balance Sheet accounts.
[1-39]WC = (Cash + AR + Inv) − (AP + TP + STD)
Example 1-4: Calculating the Working Capital for a Company
The Working Capital for the Company represented by the Balance Sheet shown in Table 1-3 can be calculated by using Equation [1-39].
Substituting the values for Cash, Accounts Receivable, Inventory, Accounts Payable, Taxes Payable, and Short-Term Debt into Equation [1-39] gives a value of $9,500,000 for Working Capital.
[1-39]WC = (Cash + AR + Inv) − (AP + TP + STD)
WC = (750,000 + 6,250,000 + 5,000,000) − (2,500,000 + 0 + 0)
WC = 12,000,000 − 2,500,000 = $9,500,000
As can be seen from this, calculating the Working Capital employed in a company is a straightforward exercise. However, when it comes to the Cash Flow Statement, dealing with Working Capital is a little more complicated.19 This will be illustrated in the following example.
Example 1-5: Calculating the Change in Working Capital
Table 1-4 shows the Working Capital accounts for the company represented by the Balance Sheet shown in Table 1-3 for the Current and Prior Years.
Table 1-4 Calculating the Change in Working Capital
The first thing that one should notice is that “Cash” is missing. The reason for this is when it comes to the Cash Flow Statement the “Change in Cash” is what the statement determines, so there is no need to be concerned about it here. More on how this works later.
When considering the impact that Working Capital has on the Cash Flow Statement, it's the change (Δ) in the various accounts that is important. The usual procedure used to determine the impact of any change in the “Asset” Working Capital accounts is to subtract the “Current Year” from the “Prior Year” to get the correct sign. When this definition is applied to the Accounts Receivable, Equation [1-40] is obtained.
[1-40]ΔAR = AR(PriorYear) − AR(CurrentYear)
Substituting
ΔAR = 5,550,000 − 6,250,000 = − $700,000
Accounts Receivable increased by $700,000. This is $700,000 of Revenues the Company didn't collect during the period covered by the financial statements and represents a use of cash and hence the negative sign.20 Similarly,
[1-41]ΔInv = Inventory(PriorYear) − Inventory(CurrentYear)
and
ΔInv = 4,350,000 − 5,000,000 = −$650,000
Here the story is the same except this time it's Inventory that increased by $650,000 from the Prior to the Current Year. Cash was used to accumulate the incremental inventory and so this represents another use of cash.
When it comes to changes in the “Liability” Working Capital Accounts the convention is to subtract “Prior Year” from the “Current Year” in order to get the sign correct. The Change in Accounts Payable is calculated with the use of Equation [1-42],
[1-42]ΔAP = AP(CurrentYear) − AP(PriorYear)
and
ΔAP = 2,500,000 − 2,400,000 = +$100,000
Accounts Payable increased by $100,000. This happened because the Company didn't pay some vendors. By not paying vendors, the Company saved $100,000 in cash.
There is no change in the Taxes Payable or Short-Term Debt, so they don't have any impact on Cash. If there had been a change, the analysis would be the same as for the other Working Capital Accounts.
When calculating The Cash Generated or Used by Working Capital, there is need for a convention. A use of Cash (in this case Accounts Receivable and Inventory) is preceded by a negative sign and a Source of Cash is preceded by a plus sign. Applying the proper sign to each term the ΔWC is simply the algebraic sum of all of the Δ's as shown in Equation [1-43].
[1-43]ΔWC = ± ΔAR ± ΔInv ± ΔAP
Substituting the calculated values with the appropriate sign in Equation [1-43] gives the Change in Working Capital.
