Working Captial Question
Working on a DCF for a case study, I am projecting revenues to grow year over year (this is not a shit co). I am projecting working capital as a % of revenues. Does it make sense for working capital to increase year over year as well? The company is generating more assets, and therefore working capital would be a greater % of revenues? The increase would be small like 50 bps a year. Is this a defendable assumption or is it stupid. First time doing this also if add this increase my valuation is much closer to what the company is currently trading at. Any help would be much appreciated.
You need to invest (i.e. buy using cash) in net working capital to generate the growth in revenue you are assuming. Think in simple terms, if you project to sell more cars, you first need to buy more inventory (i.e. inventory as one form of working capital assets go up and consume op cash). Similarly if you are selling more cars but on credit, that will lead to higher trade receivables balance until cash is collected.
What matters for DCF purpose is the operating cash flow impact from change in net working capital. Think in terms of the business model / fundamentals, how cyclical different working capital items are relative to their respective drivers, e.g. revenue for receivables, inventories, COGS for payables, etc. To the extent working capital days are relatively stable, when you grow the business, you should expect to see net cash outflows as a result of increase in net working capital. This will partially offset the higher earnings which drive your gross operating cash flow. Hence net net, you should still expect higher FCF for DCF calculation.
Hope above offers some clarity.
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