How Capex and Working Capital Affect Free Cash Flow and Valuation
A company can report strong, growing earnings and still generate very little actual cash for shareholders because earnings and cash flow are genuinely different things, and the gap between them is largely explained by two line items that rarely get the scrutiny they deserve: capital expenditure and working capital. In a DCF valuation, getting these right matters just as much as getting the revenue growth rate right.
Why Free Cash Flow Isn't the Same as Earnings
Free cash flow to the firm is typically calculated starting from EBIT, adjusted for tax, adding back depreciation and amortization (non-cash charges that reduced earnings without cash leaving the business), then subtracting both capex and the increase in net working capital.
This last subtraction is where a lot of errors originate. Earnings can grow steadily. Capex and working capital can take up a large portion of that growth in real cash terms. A business may look very profitable, on its income statement. It might hardly generate free cash flow once the true cash cost of keeping and growing it is properly accounted for.
Why Capex Deserves Careful, Explicit Modeling
Maintenance capex versus growth capex is a distinction worth making explicit rather than blending into one line. Maintenance capex keeps things running as they are. It replaces equipment and takes care of facilities. Growth capex builds for the future. It supports capacity, new locations and equipment that will help drive higher revenue. A model assuming aggressive revenue growth while projecting only maintenance-level capex is internally inconsistent, since that growth generally can't happen without the capital to support it.
Capital intensity varies enormously by industry. A capex assumption that feels right for one sector can be completely unrealistic, for another. A manufacturing or telecom company may need capex that stays between eight and twelve percent of revenue every year. An asset‑light software company could keep its capex at one or two percent and still run well. Thinking that one capex assumption fits all business types is a mistake that can be easily avoided.
Capex and depreciation matter most in the terminal year. In a mature, steady-state business, the two should converge to similar levels over the long run, since a business replacing its asset base at the rate it depreciates is neither shrinking nor expanding its capital base. A terminal value assuming capex stays meaningfully below depreciation indefinitely implicitly assumes the asset base slowly shrinks forever — rarely realistic for a business also assumed to keep growing.
Why Working Capital Investment Quietly Consumes Cash
Growing revenue almost always requires growing working capital alongside it more inventory to support higher sales, more receivables outstanding as revenue grows even at a constant collection period, offset partially by more payables if the business can extend its own payment terms.
The cash conversion cycle shows how long cash is tied up between paying suppliers and collecting from customers. The cash conversion cycle determines how much working capital a given revenue growth actually requires. A business with a long cycle needs meaningfully more working capital to support the same revenue growth than one with a short, efficient cycle, and this should show up explicitly in the projection, not get glossed over.
Working capital as a percentage of revenue is a common simplifying assumption, but it needs grounding in the company's actual historical relationship between the two, not an industry average that may not reflect its specific payment terms or inventory practices.
Common Modeling Mistakes
Ignoring the capex a projected growth rate actually requires, projecting strong revenue growth while holding capex assumptions flat or declining as a percentage of revenue, producing a free cash flow figure that's structurally too optimistic.
Using a static working capital assumption that doesn't scale realistically with the specific growth trajectory being projected, understating the cash actually consumed by a fast-growing business.
Mismatching capex and depreciation in the terminal year without a clear, justified rationale, since this single inconsistency can meaningfully distort terminal value, which typically represents the majority of a DCF's total figure.
Capex and working capital are not just tweaks hidden under the bigger revenue and margin numbers in a DCF model. They are the drivers that show the difference, between accounting profit and actual free cash flow. That’s where the true financial picture comes to life.A valuation built on strong earnings growth but unrealistic capex and working capital assumptions is quietly overstating the cash the business will actually generate, regardless of how sound its revenue projections otherwise look.
