Key10 Don't forget additional investment in working capital, plant and equipment
A project’s operating cash flows include after-tax cash revenues and expenses as well as the tax effects of depreciation. While these are easily recognized as components of project cash flows, periodic changes in net working capital and capital expenditures, which can have equally important consequences, are often overlooked.
Net working capital is defined as current assets minus current liabilities. The primary current asset items include cash and marketable securities, accounts receivable and inventories, while current liabilities include accounts payable and any other accrued liabilities, such as taxes. The items comprising net working capital are sometimes referred to as spontaneous assets and liabilities. That is, they arise spontaneously in the normal course of doing business. To help product sales, a company needs to maintain a transaction balance in cash and marketable securities. Increased sales generally require increased inventories, and credit sales generate receivables. Similarly, an increased level of sales tends to increase accounts payable, accrued taxes and other accrued expenses.
The increased current assets needed to support sales are a use of funds, which the increased current liabilities are a source of funds. Thus, any increases in net working capital are part of the cash outflows associated with a project. Changes in net working capital generally follow the pattern of sales, and it is important to include them in project cash flows. Changes in the needed working capital balance are often estimated as a fraction of the change in forecast sales from one period to the next.
It may seem strange to include any increases in cash balances as a project outflow. However, the point is that these balances must be on hand, on average, to support project-related transactions. They are tied to the project, therefore, and are not available for use elsewhere in the company. In this sense, they represent outflows from the stand-point of the rest of the company.
Changes in working capital also help reconcile accrual accounting statements with the flows of cash. As discussed under Key 2, credit sales are recognized on the income statement before customers have paid in cash. Thus, designating any increased receivables as a cash outflows offsets sales that have been included as inflows even when they have not yet been collected. In a similar fashion, accounting expenses cover only goods that have actually been sold, but do not include additions to inventory, so we need to include increased inventories as part of cash outflows. To the extent that we have not yet paid for raw materials added to inventory, however, we have generated accounts payable, and increases in payables are thus part of project inflows.
Just as projects require periodic infusions of working capital to support sales, they often require additional investments in fixed assets as well. Machines must be overhauled or replaced periodically, plants and other buildings must be renovated and maintenance expenses must be incurred. The amounts of these expenditures and the times at which they are expected to occur should be included in any accurate capital expenditure analysis.