Working capital and capex are the two adjustments between operating profit and free cash flow that turn a profitable income statement into a cash-burning business — or vice versa. Most analysts under-estimate their forecast importance and many DCFs are wrong by 10-30% because of it.
Working capital, in plain English
Working capital is the cash tied up in running the business: accounts receivable (cash you've earned but not collected), inventory (cash sitting on the warehouse floor), minus accounts payable (cash you've used but not paid out). When the business grows, working capital grows roughly in proportion. Each of those new shillings of working capital is a shilling of operating profit that did not become cash.
DSO, DPO, DIO
- DSO — Days Sales Outstanding: receivables ÷ daily revenue. Higher = customers take longer to pay you.
- DPO — Days Payable Outstanding: payables ÷ daily COGS. Higher = you take longer to pay suppliers.
- DIO — Days Inventory Outstanding: inventory ÷ daily COGS. Higher = inventory sits longer before sale.
- Cash conversion cycle = DSO + DIO − DPO. Lower (or negative, like Amazon) = the business funds growth from operations.
In a forecast, hold DSO, DPO, and DIO at their historical levels (or improve them slowly with a defended operating story) and let the absolute working-capital lines flex with revenue and COGS. This is more disciplined than picking a flat working-capital growth rate.
Maintenance capex vs growth capex
Capex splits into maintenance (replacing existing capacity as it depreciates) and growth (adding new capacity). Maintenance is a permanent cost of doing business; growth is the cash invested to fuel the revenue forecast. Crucially, depreciation is not a usable proxy for maintenance capex — depreciation reflects historical purchase prices in nominal terms, while maintenance is what the business actually spends today, in current dollars, to keep its asset base productive.
The terminal-year rule
By terminal year, growth capex should converge to a level consistent with the terminal growth rate. A business growing at 3% in perpetuity does not need to invest 12% of revenue in capex. Many DCFs leave growth-rate capex in the terminal-period FCF and quietly overstate value by 10-20%.
Exercise
A company has revenue $1B growing 10%, gross margin 40%, DSO 60, DPO 30, DIO 45. Estimate the change in net working capital required for next year.