How Capex and Working Capital Affect Free Cash Flow and Valuation
A company can report strong earnings and still generate surprisingly little cash. This is because earnings and free cash flow are not the same thing.
Two factors often explain the difference: capital expenditure (capex) and working capital. Both can have a significant impact on free cash flow and, ultimately, business valuation.
For companies valued using a Discounted Cash Flow (DCF) valuation, getting these assumptions right is essential. A business may have strong revenue growth and improving profits, but if it requires significant investment to support that growth, its actual cash generation may be much lower than expected.
What Is Free Cash Flow to the Firm (FCFF)?
Free Cash Flow to the Firm (FCFF) represents the cash generated by a business that is available to all capital providers, including debt and equity investors.
A simple FCFF formula is:
FCFF = EBIT × (1 − Tax Rate) + Depreciation & Amortization − Capex − Increase in Net Working Capital
This formula highlights an important point: profit alone does not determine free cash flow.
A company may report growing earnings while spending heavily on new equipment, inventory, or customer receivables. These cash requirements reduce the amount of cash the business actually generates.
How Capital Expenditure (Capex) Affects Free Cash Flow
Capital expenditure is the money a company invests in long-term assets needed to operate and grow the business.
Capex can generally be divided into:
- Maintenance capex: Spending required to maintain existing operations and replace assets.
- Growth capex: Investment required to expand capacity, open new locations, purchase equipment, or support future growth.
This distinction matters when building a DCF valuation. If a business is expected to grow rapidly, the forecast should reflect the investment required to support that growth.
Projecting strong revenue growth while keeping capex unrealistically low can result in overstated free cash flow and an inflated business valuation.
Why Industry Matters When Estimating Capex
Capex requirements can vary significantly between industries. A manufacturing or telecom company may require substantial investment in physical assets, while an asset-light software company may require considerably less capital expenditure.
Therefore, capex assumptions should be based on the company's business model, historical spending, expected growth, and industry characteristics rather than applying the same percentage to every business.
Capex and Depreciation in Terminal Value
Capex also becomes particularly important when calculating the terminal value in a DCF. For a mature business expected to operate over the long term, capex would generally be expected to broadly align with depreciation as the company replaces its existing asset base.
Assuming capex remains significantly below depreciation indefinitely may imply that the company's asset base is gradually shrinking, which may not be consistent with long-term growth.
How Working Capital Affects Free Cash Flow
Working capital represents the capital tied up in a company's day-to-day operations.
Working Capital = Current Assets − Current Liabilities
It can include inventory, customer receivables, and amounts owed to suppliers.
Working capital is different from profit. A company can report strong earnings while still having significant cash tied up in inventory or unpaid customer invoices.
This becomes especially important for growing companies. As revenue increases, the business may need more inventory and may have more money tied up in receivables.
Working Capital in a DCF Valuation
Working capital directly affects free cash flow. When working capital increases, the business uses cash and FCFF decreases. When working capital decreases, cash is released and FCFF increases. One common DCF modeling mistake is assuming that working capital will remain at a fixed percentage of revenue throughout the forecast period. This may not reflect the company's actual operating cycle.
A better approach considers historical working-capital trends, payment terms, inventory requirements, expected growth, and the company's ability to collect cash from customers.
Cash Conversion Cycle and Working Capital Efficiency
The cash conversion cycle (CCC) helps measure how efficiently a business converts its investment in operations back into cash.
Three commonly used metrics are:
- Days Sales Outstanding (DSO): How quickly customers pay their invoices.
- Days Inventory Outstanding (DIO): How long inventory remains before being sold.
- Days Payable Outstanding (DPO): How long the company takes to pay suppliers.
A shorter cash conversion cycle generally means less cash is tied up in day-to-day operations.
These metrics can also highlight potential issues. For example, receivables growing faster than revenue may indicate slower collections, while inventory growing faster than sales may point to excess stock or weaker demand.
Working Capital and M&A Valuation
Working capital can also affect the purchase price in an M&A transaction. Purchase agreements often establish a target level of working capital based on the company's normal operating requirements. The actual working capital delivered at closing is then compared with that target.
If the company delivers more or less working capital than the agreed level, the purchase price may be adjusted accordingly.
This makes working capital important not only for DCF valuation but also for business acquisitions and transaction negotiations.
How Industry Differences Affect Working Capital
Working capital requirements can vary significantly across industries.
- Retail businesses may operate with low or negative working capital because customers typically pay immediately while suppliers may be paid later.
- Manufacturing companies often require more working capital because they maintain inventory and may have significant receivables.
- SaaS and subscription businesses can have relatively low working-capital requirements, particularly when customers pay upfront.
Therefore, working capital should always be assessed in the context of the company's specific business model rather than relying solely on industry averages.
Common DCF Modeling Mistakes
Some common mistakes can make free cash flow and business value appear higher than they should be:
- Underestimating capex: Projecting strong growth without enough investment to support it.
- Using unrealistic working-capital assumptions: Applying a fixed percentage of revenue without considering actual operating trends.
- Ignoring industry differences: Using generic capex or working-capital assumptions that do not fit the business.
- Mismatching capex and depreciation: Assuming significantly lower terminal capex without a clear reason.
These assumptions may appear minor individually, but together they can materially affect free cash flow and the final valuation.
Why Capex and Working Capital Matter for Business Valuation
Capex and working capital are not simply supporting figures in a valuation model. They help explain the difference between accounting profit and actual cash generation.
A company may have strong earnings growth, but if it requires substantial investment in assets, inventory, or receivables, much of that profit may not translate into cash.
This is why a reliable business valuation should look beyond revenue and EBITDA and consider how much cash the business actually generates after meeting the investment required to operate and grow.
Conclusion
Understanding capex, working capital, and FCFF is essential when valuing a business, particularly through a DCF approach.
Strong earnings do not automatically mean strong cash flow. If a company needs significant capital expenditure or working capital to support its growth, those cash requirements must be reflected in the valuation.
Ultimately, the key question is simple:
How much cash does the business actually generate, and how much cash does it need to support future growth?
Getting that answer right can make the difference between a realistic business valuation and one that looks attractive on paper but overstates the company's true cash-generating potential.
