Question

Why do we want to include Net Working Capital in our calculation to convert unlevered net income to free cash flow?

Answer 1

Unlevered net income is the earnings before interest & taxes .

This amount is unlevered-- ie. Without deducting interest payments on debt(consequence of being levered or adding debt to the capital structure)

Free cash flow= EBIt*(1-Tax rate)+Depn.& amortisations-CAPEX-Net Changes to working capital

Depn.& amortisations are non-cash allocations /expenses --just to recover the asset value--as allowed under GAAP

CAPEX are the capital expenditures which are funded by the free cash generated

We include Net working capital in the FCF calculation as any change in the working capital components ,namely, current assets or current liabilities ,increases /decreases cash flows

ie. For example,increase in inventory means cash spent --so cash balance decreases.

similarly,decrease in accounts payables means paying off suppliers --so decreases cash

same way,increase in liabilities,like salary payable,implies with-holding of cash within the organisation &

decrease in inventory means, sale which brings in cash & thr cash flow increases.

AS the components of working capital, namely, the current assets & current liabilities .are created& incurred specifically during the conduct of the business & its operating activities --the cash flows involved in the process of their creation/reduction --are considered to arrive at the free cash flow figure.