Capital Expenditures and Working Capital#

You've projected revenue and margins—now you understand how much operating profit the company will generate. But not all of that profit becomes Free Cash Flow. Two major items reduce cash available to investors: Capital Expenditures (CapEx) and Working Capital investments.

Understanding Capital Expenditures#

Capital expenditures are investments in long-term assets: buildings, equipment, technology infrastructure, vehicles. Unlike operating expenses, CapEx is capitalized on the balance sheet and depreciated over time.

Maintenance CapEx vs. Growth CapEx#

This distinction is crucial for valuation:

Example: Retail Chain

Total CapEx: $500M
- Maintenance (store refurbishments, equipment): $200M
- Growth (30 new stores × $10M each): $300M

For valuation:
- Mature company: Focus on maintenance CapEx
- Growing company: Consider total CapEx but expect returns from growth portion

Approaches to Projecting CapEx#

Method 1: CapEx as % of Revenue#

The simplest approach—assume CapEx maintains a historical relationship to revenue.

Observation: CapEx intensity is declining. This could mean:

• The company is mature (less growth investment needed)
• It's under-investing (could hurt future growth)
• It's becoming more efficient

Projection: Use 7-8% of revenue going forward, unless there's reason to expect a change.

Method 2: CapEx as Multiple of Depreciation#

Since maintenance CapEx approximates depreciation, you can use this relationship:

Example:

Current Depreciation: $50M
For a growing company: CapEx = $50M × 1.5 = $75M
For a mature company: CapEx = $50M × 1.1 = $55M

Method 3: Bottom-Up by Project#

For companies with visible investment programs:

Projected CapEx 2025:
- New factory in Texas: $200M (announced)
- IT infrastructure upgrade: $50M (planned)
- Maintenance across facilities: $80M (estimated)
- Total: $330M

This approach works well when companies disclose investment plans.

Industry CapEx Benchmarks#

Capital intensity varies dramatically by industry:

Understanding Working Capital#

Working capital represents cash tied up in day-to-day operations. The key components:

Operating Working Capital Formula#

Operating Working Capital = Current Operating Assets - Current Operating Liabilities

Specifically:
= (Accounts Receivable + Inventory + Prepaid Expenses)
- (Accounts Payable + Accrued Expenses)

Note: Exclude cash and debt—those are financing, not operating items.

How Working Capital Uses (or Generates) Cash#

The Golden Rule: Increases in working capital use cash; decreases generate cash.

Example: Growing Company's Working Capital#

Year 1: $100M revenue
- Receivables (60 days sales): $16.4M
- Inventory (45 days sales): $12.3M
- Payables (30 days): $8.2M
- Working Capital: $20.5M

Year 2: $120M revenue (20% growth)
- Receivables (same terms): $19.7M
- Inventory (same terms): $14.8M
- Payables (same terms): $9.9M
- Working Capital: $24.6M

Change in Working Capital: $24.6M - $20.5M = $4.1M (cash outflow)

This $4.1M is subtracted in the Free Cash Flow calculation—even though it's not an "expense," the cash is tied up.

Projecting Working Capital#

Method 1: Working Capital as % of Revenue#

The most common approach:

If WC is 11% of revenue and stays constant:

• When revenue grows from $720M to $800M
• Working capital goes from $79M to $88M
• Cash used = $9M

Formula for Forecasting:

Change in WC = WC % × (New Revenue - Old Revenue)
Change in WC = 11% × ($800M - $720M) = $8.8M

Method 2: Days-Based Analysis#

More precise but requires more data:

This approach helps when you expect terms to change (e.g., company tightens credit).

Negative Working Capital: The Cash Machine#

Some businesses actually generate cash from working capital. This happens when:

Example: Amazon-Like Retailer

- Customers pay immediately (credit card)
- Inventory turns in 20 days
- Pays suppliers in 60 days

Working Capital = Receivables (0) + Inventory (low) - Payables (high)
= Negative!

As revenue grows, working capital becomes MORE negative
= Cash generation from operations

Putting It All Together: Free Cash Flow Build#

Let's complete the projection for TechCorp:

Key assumptions:

• Tax rate: 25%
• Depreciation: ~3% of revenue, growing
• CapEx: 4% of revenue (CapEx > D&A indicates growth investment)
• Working Capital: 10% of revenue (change = 10% × revenue growth)

Common Mistakes#

1. Ignoring CapEx Entirely#

Some analysts project EBITDA as if it were cash flow. It's not. CapEx is real and recurring.

2. Projecting CapEx Below Depreciation Forever#

If CapEx stays below depreciation, the company is effectively shrinking its asset base. This can't continue indefinitely for most businesses.

3. Forgetting Working Capital in Growth#

Fast-growing companies often face "working capital squeeze"—profits look great, but cash is trapped in inventory and receivables. This has killed many seemingly healthy businesses.

4. Using Total Working Capital#

Remember: exclude cash and debt. Only operating working capital affects Free Cash Flow calculations.