12.2 Working Capital Modeling

The Working-Capital Schedule Feeds Both the Three Statements and DCF

Chapter 10 articulated ΔNWC as a cash-from-operations line and as a plug risk if the sign is wrong. Chapter 5 defined liquidity ratios and the cash conversion cycle as analysis. This section is the forecast schedule: you pick days (or percents), compute the stocks on the balance sheet, then compute the change that hits cash. CFI's Operational Modeling course treats that schedule as a peer of the revenue build and the PP&E roll-forward, because unlevered free cash flow subtracts the same ΔNWC the cash flow statement subtracts.

Operating net working capital (NWC) for modeling:

NWC = AR + Inventory + other operating current assets − AP − other operating current liabilities

Exclude cash (the cash flow statement explains cash) and exclude interest-bearing debt (the revolver, commercial paper, and current portion of long-term debt belong on the debt schedule). Prepaid expenses and accrued expenses stay in. Deferred revenue is an operating current liability when it comes from customer prepayments. Income-tax payable can be treated as operating if the case keeps it; many compact models ignore it.

Exam trap: using current assets − current liabilities as the forecast NWC line. That accounting total includes cash and short-term debt. If you then also solve for cash and also roll the revolver, you have counted financing twice and the model will only balance by accident.

Days Methods: Turn Drivers into Stocks

The default CFI construction uses a 365-day year unless the case specifies 360. Historical days are computed from last year's statements; forecast days are inputs (hold constant, improve, or stretch).

Accounts receivable (AR) = DSO × Sales / 365

Inventory = DIO × COGS / 365

Accounts payable (AP) = DPO × COGS / 365 (or DPO × Purchases / 365)

Days sales outstanding (DSO) uses sales because receivables come from billed revenue, not from COGS. Days inventory outstanding (DIO) and days payable outstanding (DPO) use COGS at a manufacturer because inventory and payables are tied to product cost. A retailer or a trading company may give purchases for DPO; purchases = COGS + Δinventory (ignoring inventory write-offs).

Northstar Year 0 drivers, from section 12.1: sales $50,000,000, COGS $28,000,000. Forecast days, held constant in Year 1: DSO 45, DIO 60, DPO 40. Other operating current assets (prepaids) = 0.8% of sales. Other operating current liabilities (accruals) = 1.6% of sales.

Year 0 stocks (historical, but compute them as a check)

If the historical balance sheet does not match these implied stocks, you have two honest choices: (1) back into the actual historical days and use those days as the Year 0 starting point, or (2) accept a Day-1 true-up and disclose it. Do not force the historical AR cell to equal 45-day AR and keep the reported AR number — that is two AR figures.

Year 1 stocks (forecast: days hardcoded, dollars computed)

Year 1 sales $54,075,000, COGS $29,988,000 from section 12.1.

This is the invert from Chapter 10: historical years can hardcode the stocks and compute days; forecast years hardcode the days and compute the stocks. Copying Year 0's $6,164,384 of AR into Year 1 while sales rose 8.15% is a silent DSO cut from 45 days to 41.6 days. If the case wants a collection improvement, change DSO on the assumptions tab. Do not bury it in a hardcoded stock.

Worked ΔNWC

ΔNWC = NWC_t − NWC_{t−1} = $7,877,414 − $7,298,631 = +$578,783

Walk it by account so the sign convention is mechanical:

Asset increases use cash. Liability increases source cash. Net asset growth of $578,783 is subtracted on the indirect cash flow statement and subtracted again in UFCF. Get the sign backwards and Year 1 cash, the revolver, interest, and every subsequent year are wrong.

A percent-of-sales shortcut, ΔNWC ≈ (NWC_0 / Sales_0) × ΔSales, is a sanity check, not the schedule. Northstar NWC / sales in Year 0 is 7,298,631 / 50,000,000 = 14.60%. 14.60% × $4,075,000 of extra sales ≈ $594,850, which is close to $578,783 but not equal, because inventory and AP scale with COGS, and COGS% fell from 56.0% to 55.5% when price outran unit cost. Use the days formulas; use the ratio only to ask "is $578,783 a plausible order of magnitude?"

Cash Conversion Cycle

The cash conversion cycle (CCC) is the days version of the same operating stock:

CCC = DIO + DSO − DPO

Northstar: 60 + 45 − 40 = 65 days. The firm invests in inventory for 60 days, waits 45 days to collect, and finances 40 days of that with suppliers. About 65 days of the cycle must be funded with cash, a revolver, or longer-term capital.

A shorter CCC usually frees cash: collect faster (cut DSO), turn inventory faster (cut DIO), or stretch payables (raise DPO). Stretching DPO is a source of cash until suppliers cut you off or raise price. Negative CCC (DPO longer than DIO + DSO) means the operating cycle provides cash as the firm grows — some retailers collect from customers before they pay vendors.

Exam trap: adding DPO instead of subtracting it. Payables are a source. CCC = 60 + 45 + 40 = 145 days is the wrong cycle.

Map CCC back to dollars only with care. You cannot multiply 65 days by sales / 365 and call it NWC, because DIO and DPO sit on COGS while DSO sits on sales, and other CA/CL are extra. Northstar's $7,298,631 NWC is 53.3 days of sales ($7,298,631 / $50,000,000 × 365), not 65, precisely because of that mix of bases plus accruals and prepaids. Days are for forecasting each stock. CCC is the summary statistic.

Purchases Versus COGS in the Payables Formula

If inventory is rising, the firm purchased more than it expensed. Year 1 purchases = COGS + Δinventory = $29,988,000 + $326,959 = $30,314,959. AP from DPO × purchases / 365 = 40 × 30,314,959 / 365 = $3,322,187, which is $35,721 higher than AP from DPO × COGS. On a compact annual case, CFI-style models usually use COGS for both inventory and payables so the two formulas share a denominator. If the prompt says purchases, use purchases. Do not mix: DIO on COGS and DPO on purchases is fine; DPO on sales is not (that would treat payables as if suppliers billed list price).

Seasonality and the Annual Days Approximation

Section 12.1's Q4 is 35% of annual sales. The annual AR formula, 45 × $54,075,000 / 365 = $6,666,781, assumes a flat daily run-rate. Trailing 45 days of Q4 sales is about $9,360,000. An annual FMVA case that gives only annual sales expects the annual formula. A monthly operational model should compute AR from recent sales × DSO / days in the lookback, not from annual sales. Using annual DSO on a peak-season year-end understates AR, understates NWC, and overstates cash — the opposite of how a holiday manufacturer actually feels in December.

Growth at Constant Days Still Consumes Cash

Hold Northstar's 45 / 60 / 40 days and the other CA/CL percents constant, and NWC must rise with the operating model. That is not a deterioration. It is the working-capital investment required to support 5% more volume and 3% more price. Candidates sometimes "help" cash by freezing AR, inventory, and AP in dollars. That freeze is a 13-day DSO improvement (45.0 to 41.6) plus similar gifts on inventory and payables — a CCC cut you did not disclose. If the case wants efficiency, cut the day counts on the driver tab and show the cash release as a separate bridge.

The opposite trap: stretching DSO to 50 days in Year 1, perhaps because the sales team bought volume with terms.

AR at 50 days = 50 × $54,075,000 / 365 = $7,407,534, which is $740,753 more cash in receivables than the 45-day case. ΔNWC becomes $578,783 + $740,753 = $1,319,536. EBIT in section 12.1 does not see this. Cash and UFCF do. That is why operational modeling is a set of schedules, not a P&L-only exercise.

Linking the Schedule

1. Driver tab: DSO, DIO, DPO, other CA%, other CL% (blue inputs in forecast years).
2. Working-capital schedule: AR, inventory, other CA, AP, other CL, NWC, ΔNWC (black formulas).
3. Balance sheet: each stock references the schedule, not a percent typed on the face of the BS.
4. Cash flow statement: −ΔNWC in CFO (if NWC rose, cash fell).
5. UFCF: −ΔNWC again, alongside NOPAT, D&A, and capex from section 12.3.

Do not forecast ΔNWC as a percent of sales independently of the stocks. The change is the difference of two balance sheets. Forecast the stocks; the change will follow. Northstar's Year 1 $578,783 outflow is the number that will sit next to the $10 million capex outflow in 12.3 when we compute UFCF.