4. Working Capital.pptx

Financial Modeling Fundamentals:
4. Working Capital

OVERVIEW
In reality the revenue and expenses reported on the
income statement rarely equal their corresponding cash
receipts and payments in each period as a result of
timing differences between invoices and cash flows.
For revenue and operating expenditure, these timing
differences result in debtors and creditors – also known
as accounts receivable and accounts payable – on the
balance sheet, reflecting revenue not received in cash
and expenses not paid in cash at the end of each
period respectively.
And movements in debtors and creditors are offset by
cash flow adjustments called working capital
adjustments.
For cost of goods sold, these timing differences are
handled by modeling inventory, which sits on the
balance sheet of a business for a period of time
between its purchase from suppliers and sale to
customers.
The key reason for differences between income
statement revenue and expenses and cash flow
statement cash flows is accrual accounting, which
requires that revenue or expenses are recorded when a
transaction occurs rather than when cash payment is
received or made.

OVERVIEW
Debtors, creditors, and inventory are all part of
the working capital of a business, and must be
incorporated in a financial model to ensure that cash
flows are modeled realistically, rather than simply
assuming accrued revenues and expenses equal cash
flows.
The simplest and most common method used to model
working capital is the days approach, in which
revenues and expenses are assumed to be earned and
received evenly throughout each period, with a
proportion of these revenues and expenses not being
received or paid in cash before the end of the period.
This proportion is expressed as a number of days
relative to the total number of days in the period.
.

OVERVIEW
For example, consider a business which accrues sales
(i.e. sends out invoices) of $1,000 during a year, but
only $900 of these revenues have been received in
cash (i.e. paid by customers) by the end of the year.
If it is assumed that these revenues were earned
evenly throughout the year, and that the corresponding
cash amounts were also received evenly, the following
bar chart can be used to represent the working capital
position of the business as it relates to these sales:
Debtors – Revenues vs. Cash Receipts Example

OVERVIEW
The bars representing revenue and cash receipts clearly show the time lag between
sending out invoices and receiving cash from the payment of these invoices. In this
case, the unpaid invoices at the end of the year represent 10% of the total sales for
the year, which equates to 36.5 debtor days based on a 365-day year.
Hence, it can then be said that the average debtor days for the revenues of the
business in the above example is 36.5 days – i.e. on average the business gets paid
36.5 days after invoicing customers.
This basic working capital calculation is summarized below for debtors, inventory,
and creditors:
Working Capital Days – Calculations

DEBTORS
Debtors refers to amounts owing to a business for
goods and services provided to customers but not yet
paid for in cash. Debtors are also commonly referred
to as accounts receivable (AR).
Apple's debtors for the past two financial years can be
found within the current assets section of its balance
sheet on page 33 of its annual report.
Apple's FY20 closing debtors balance was $16,120m,
which based on total revenue of $274,515m and 366
days in FY20 implies an average debtor days of 21.5
days (i.e. $16,120m ( $274,515m × 366).
This is a significant decrease from the FY19 closing
debtors balance of $22,926m, which based on total
revenue of $260,174m implies an average debtor
days of 32.2 days (i.e. $22,926m ( $260,174m × 365),
as shown here:
Apple – Debtors

DEBTORS
Note that Apple also reported $21,325m of Vendor
non-trade receivables within its current assets.
As discussed in the notes on page 45 of the annual
report, these relate to the sale of components to
manufacturing vendors rather than customers. For
simplicity they will not be included within debtors in
the Apple financial model.
In the Apple financial model, activate the opening
balance sheet in position 1.b. of the table of contents.
Enter the FY20 closing balance of $16,120m as the
debtors opening balance assumption into cell J7, as
shown below:
Debtors – Opening Balance
Sheet

DEBTORS
Note that while the opening balance
sheet automatically balances via the
retained profits balancing item, the
forecast balance sheet disbalances
because it does not yet allow for the
inclusion of debtors in the forecasts.
Activate the forecasts sheet in position
1.c. of the table of contents.
The debtors forecast assumptions are
located in row 18, as shown here:
Debtors –
Assumptions

DEBTORS
A debtor days assumption of 25 days has
been assumed in all periods, being
somewhere in between the FY19 average
debtor days of 32.2 days and the FY20
average debtor days of 21.5 days.
Based on assumed revenue of $289,613m
and 25 debtor days, Apple's forecast closing
debtors balance for FY21 is $19,837m (i.e.
$289,613m × 25 days ( 365 days). This is a
$3,717m increase from the opening balance
sheet debtors balance of $16,120m.
Because the underlying revenue has already
been reported in the income statement and
cash flow statement, this increase in debtors
only impacts the financial statements by
adding to debtors on the balance sheet and as
a downwards adjustment to cash receipts on
the cash flow statement, as shown here:
Debtors – Financial Statement Impacts (FY21)

DEBTORS
This diagram shows only the financial
statement impacts of debtors during
FY21 – i.e. an increase in debtors of
$3,717m and a corresponding
downwards cash adjustment.
The financial statement impacts of
debtors make more sense when
viewed in conjunction with its
underlying revenue, as shown below
for Apple for FY21:
Revenue & Debtors – Financial Statement Impacts
(FY21)

DEBTORS
Note that income statement NPAT and balance sheet retained profits include the entire $289,613m of revenue earned during FY21, but
after putting through a negative cash adjustment of $3,717m to reflect the increase in debtors only $285,896m of this revenue is reported
as cash on the balance sheet at the end of FY21.
Note that the terminology Decrease in Debtors has been used for the debtors cash adjustment, reflecting the fact that an increase in
debtors implies a decrease in cash received during the period. Because the cash flow statement is expressed in terms of positive cash
flows, a decrease in debtors results in a positive cash adjustment.
Activate the balance sheet (in position 2.b. of the table of contents), then add debtors by entering the following heading into column B and
data in columns J – N of the following row:
Row Heading Data
15 Debtors =IS!J12*Forecasts!J18/(J$6-J$5+1)

DEBTORS
This formula multiplies revenue by the debtor days assumption before dividing by the number of days in the period.
To allow for leap years, the number of days in the period has been calculated based on the period start and end dates in the
period titles rows 6 and 7 respectively – i.e. it is equal to the period end date minus the period start date plus one.
In FY21 this returns 365 days.
Ensure that debtors are included in total current assets by amending the existing total current assets formula in cell J18 with
the following formula, then copy and paste across the range J18:N18:
=SUM(J14:J15)
Row Heading Data
15 Debtors =IS!J12*Forecasts!J18/(J$6-J$5+1)

DEBTORS
After doing this, the total current assets forecasts
should start at $137,263m in FY21 and increase to
$471,209m in FY25, as shown here
Balance Sheet – Debtors

DEBTORS
Debtors have now been included in the balance sheet, but it still does not balance because the cash flow statement does not
include the adjustment to cash required to reflect the increase in debtors of $3,717m during FY21.
To add this cash adjustment, activate the cash flow statement (sheet in position 2.c. of the table of contents) then expand the
collapsed period titles rows 5 – 8 to unhide the period counters in row 7. Then add the debtors cash adjustment by entering
the following heading into column C and data in columns J – N of the following row:
Row Heading Data
13 Decrease in Debtors =IF(J$7=1,OBS!$J7,BS!I15)-BS!J15
This formula calculates the decrease in debtors in each period by subtracting the current period debtors balance from the
prior period debtors balance. In the first forecast period, the prior period debtors balance must be sourced from the opening
balance sheet, while in subsequent periods it is sourced from the prior cell in the balance sheet.
Ensure that this decrease in debtors is included in cash receipts by amending the formula in the cash receipts calculation cell
J14 with the following formula, then copy and paste across the range J14:N14:
=SUM(J12:J13)

DEBTORS
After doing this, cash receipts should
equal $285,896m in FY21 and
increase to $357,435m in FY25, and
the balance sheet should balance, as
shown here:
Cash Flow Statement – Decrease in Debtors

DEBTORS
Note that the balance sheet now
balances because the movement in
debtors on the balance sheet in each
period is offset by a corresponding
cash adjustment in the cash flow
statement, which flows through to net
assets via cash.
Now that the cash receipts sub-
section of the cash flow statement is
complete, group and collapse rows
12 – 13 to hide the cash receipts
detail rows by default, as shown here
Cash Flow Statement – Cash Receipts

Inventory refers to the raw materials used by a
business in production as well as the goods produced
that are available for sale. Inventory is added to the
balance sheet as an asset when it is purchased and
removed from the balance sheet via cost of goods sold
on the income statement when sold to customers.
The modeling of inventory can be one of the most
complex parts of a financial model, with a wide range of
methods available depending on the type of business
and level of detail required.
Like debtors and creditors, the simplest and most
common method to model inventory is the days
approach, whereby inventory is assumed to be
purchased and sold evenly throughout each period,
with a proportion of inventory not being sold before the
end of the period. This proportion is expressed as a
number of days relative to the total number of days in
the period.
Apple's inventory for the past two financial years can be
found within the current assets section of its balance
INVENTORY

Apple's FY20 closing inventory balance was $4,061m,
which based on total cost of goods sold (excluding D&A) of
$158,503m and 366 days in FY20 implies an average
inventory days of 9.4 days (i.e. $4,061m ( $158,503m ×
366).
This compares with the FY19 closing inventory balance of
$4,106m, which based on total cost of goods sold
(excluding D&A) of $149,235m implies an average inventory
days of 10.0 days (i.e. $4,106m ( $149,235m × 365), as
shown here:
It should be noted that the modeling of inventory using an
inventory days approach is a greater simplification of reality
than the use of the days approach when modeling debtors
and creditors.
This is because for debtors and creditors their
corresponding cash receipts and payments are driven by
the issuing and receipt of invoices, and the period of time in
between invoice creation and payment is the debtor or
creditor days.
Apple – Inventory
INVENTORY

In reality, inventory is added to the balance sheet
when it is purchased and expensed through cost of
goods sold on the income statement when it is sold,
with the period of time in between being the inventory
days.
Hence, applying inventory days to cost of goods sold
in a financial model is a major simplification because
inventory is being driven by cost of goods sold, which
is the opposite of reality.
But for the modeling of most steady state businesses
this approach is usually acceptable because it
achieves the primary objective of establishing a
relationship between inventory and cost of goods
sold. And because cost of goods sold is usually
related to revenue (e.g. via margin assumptions), this
means inventory forecasts are also related to revenue
forecasts.
inventory opening balance assumption into cell J8, as
Inventory – Opening Balance Sheet
INVENTORY

Note that while the opening balance sheet
automatically balances via the retained profits
balancing item, the forecast balance sheet
disbalances because it does not yet allow for
the inclusion of inventory in the forecasts.
Activate the forecasts sheet in position 1.c. of
the table of contents. The inventory forecast
assumptions are located in row 19, as shown
below: Inventory – Assumptions
INVENTORY

An inventory days assumption of 9 days has
been assumed in all periods based on average
inventory days reducing from 10.0 days in
FY19 to 9.4 days in FY20.
Based on assumed cost of goods sold
(excluding D&A) of $166,817m and 9 inventory
days, Apple's forecast closing inventory
balance for FY21 is $4,113m (i.e. $166,817m ×
9 days ÷ 365 days). This is a $52m increase
from the opening balance sheet debtors
balance of $4,061m.
Because the underlying cost of goods sold has
already been reported in the income statement
and cash flow statement, this increase in
inventory only impacts the financial statements
by adding to inventory on the balance sheet
and as a downwards adjustment to cash
payments on the cash flow statement, as
shown here:
statement impacts of inventory during FY21 –
i.e. an increase in inventory of $52m and a
Inventory – Financial Statement Impacts (FY21)
INVENTORY

The financial statement impacts of inventory
make more sense when viewed in conjunction
with its underlying cost of goods sold, as
shown below for Apple for FY21:
Note that income statement NPAT and balance
sheet retained profits include $166,817m of
cost of goods sold during FY21, but the cash
flow statement also includes $52m of inventory
purchased during this year that was not sold
and instead remained on the balance sheet at
the end of FY21.
Note that the terminology Decrease in
Inventory has been used for the inventory cash
adjustment, reflecting the fact that
a decrease in inventory implies an increase in
cash during the period – i.e. from the business
selling more inventory than it purchases.
Conversely, the increase in inventory reflects
greater inventory purchases than sales, which
is reflected in the negative cash adjustment.
INVENTORY
Cost of Goods Sold & Inventory – Financial Statement
Impacts (FY21)ry – Financial Statement Impacts (FY21)

Activate the balance sheet (in position 2.b. of the table of contents), then add inventory by entering the following
heading into column B and data in columns J – N of the following row:
Row Heading Data
16 Inventory =-IS!J13*Forecasts!J19/(J$6-J$5+1)
This formula multiplies cost of goods sold by the inventory days assumption before dividing by the number of days in
the period, allowing for leap years. It also negates the result because cost of goods sold is expressed as a negative
number on the income statement.
Ensure that inventory is included in total current assets by amending the existing total current assets formula in
cell J18 with the following formula, then copy and paste across the range J18:N18:
=SUM(J14:J16)
INVENTORY

After doing this, the
total current assets
forecasts should start at
$137,660m in FY21
and increase to
$467,851m in FY25, as
shown here:
Inventory has now been
included in the balance
sheet, but it still does
not balance because
the cash flow statement
does not include the
adjustment to cash
required to reflect the
increase in inventory of
$52m during FY21.
INVENTORY
Balance Sheet – Inventory

To add this cash adjustment, activate the cash flow statement (sheet in position 2.c. of the table of contents), then
enter the following heading into column C and data in columns J – N of the following row:
Row Heading Data
17 Decrease in Inventory =IF(J$7=1,OBS!$J8,BS!I16)-BS!J16
This formula calculates the decrease in inventory in each period by subtracting the current period inventory balance
from the prior period inventory balance. In the first forecast period, the prior period inventory balance must be sourced
from the opening balance sheet, while in subsequent periods it is sourced from the balance sheet.
Ensure that this decrease in inventory is included in cash payments by amending the formula in the cash payments
calculation cell J19 with the following formula, then copy and paste across the range J19:N19:
=SUM(J15:J17)
INVENTORY

After doing this, cash
payments should equal
$210,254m in FY21 and
increase to $275,692m in
FY25, and the balance
sheet should balance, as
shown here:
Note that the balance sheet
now balances because the
movement in inventory on
the balance sheet in each
period is offset by a
corresponding cash
adjustment in the cash flow
statement, which flows
through to net assets via
cash.
INVENTORY
Cash Flow Statement – Decrease in Inventory

Creditors refers to amounts owed by a business for
goods to vendors or suppliers for goods or services
received that have not yet been paid for in cash.
Creditors are also commonly referred to as accounts
payable (AP).
Apple's creditors for the past two financial years can be
found within the current liabilities section of its balance
To calculate implied creditor days for Apple, both cost of goods
sold (excluding D&A) and operating expenditure will be used
because it can reasonably be assumed that a portion of the
total creditors on Apple's balance sheet relates to inventory
purchases.
Apple's FY20 closing creditors balance was $42,296m, which
based on total cost of goods sold and operating expenditure of
$197,171m (i.e. cost of goods sold of $158,503m and
operating expenditure of $38,668m) and 366 days in FY20
implies an average creditor days of 78.5 days (i.e. $42,296m (
$197,171m × 366).
CREDITORS

This is a significant decrease from the FY19 closing
debtors balance of $46,236m, which based on total
cost of goods sold and operating expenditure of
$183,697m (i.e. cost of goods sold of $149,235m
and operating expenditure of $34,462m) implies an
average creditor days of 91.9 days (i.e. $46,236m (
183,697m × 365), as shown here:
Apple – Creditors
CREDITORS

creditors opening balance assumption into cell J18,
as shown here:
Creditors – Opening Balance Sheet
CREDITORS

Note that while the opening balance sheet
automatically balances via the retained profits
balancing item, the forecast balance sheet
disbalances because it does not yet allow for
the inclusion of creditors in the forecasts.
Activate the forecasts sheet in position 1.c. of
the table of contents. The creditors forecast
assumptions are located in row 20, as shown
below: Creditors – Assumptions
CREDITORS

A creditor days assumption of 80 days has
been assumed in all periods, being somewhere
in between the FY19 average creditor days of
91.9 days and the FY20 average creditor days
of 78.5 days.
Based on forecast cost of goods sold of
$166,817m and operating expenditure of
$43,385m and 80 creditor days, Apple's
forecast closing creditors balance for FY21 is
$46,072m (i.e. ($166,817m + $43,385m) ×
80 days ( 365 days).
This is a $3,776m increase from the opening
balance sheet creditors balance of $42,296 m.
Because the underlying cost of goods sold and
operating expenditure has already been
reported in the income statement and cash
flow statement, this increase in creditors only
impacts the financial statements by adding to
creditors on the balance sheet and as an
upwards adjustment to cash payments on the
cash flow statement, as shown here:
Creditors – Financial Statement Impacts (FY21)
CREDITORS

statement impacts or creditors during FY21 –
i.e. an increase in creditors of $3,776m and a
corresponding upwards cash adjustment.
The financial statement impacts of creditors
make more sense when viewed in conjunction
with its underlying cost of goods sold and
operating expenditure, as shown below for
Apple for FY21:
CREDITORS
COGS, Operating Expenditure & Creditors – Financial
Statement Impacts (FY21)

Note that income statement NPAT and balance sheet retained profits includes the entire $210,202m of cost of goods
sold and operating expenditure during FY21, but after putting through a positive cash adjustment of $3,776m to reflect
the increase in creditors only $206,427m of these expenses is reported as cash on the balance sheet at the end of
FY21.
Note that the terminology Increase in Creditors has been used for the creditors cash adjustment, reflecting the fact
that an increase in creditors implies an increase in cash during the period – i.e. bills expensed through the income
statement but not yet paid.
Activate the balance sheet (in position 2.b. of the table of contents), then add creditors by entering the following
heading into column B and data in columns J – N of the following row:
Row Heading Data
26 Creditors =-(IS!J13+IS!J15)*Forecasts!J20/(J$6-J$5+1)
Like with debtors, this formula multiplies the sum of cost of goods sold and operating expenditure by the creditor days
assumption before dividing by the number of days in the period.
Ensure that creditors are included in total current liabilities by overwriting the zero value in the total current liabilities
formula in cell J31 with the following formula, then copy and paste across the range J31:N31:
=J26
CREDITORS

After doing this, the total current
liabilities forecasts should start at
$46,072m in FY21 and increase to
$60,365m in FY25, as shown here:
Creditors have now been included in
the balance sheet, but it still does
not balance because the cash flow
statement does not include the
adjustment to cash required to
reflect the increase in creditors of
$3,776m during FY21.
CREDITORS
Balance Sheet – Creditors

To add this cash adjustment, activate the cash flow statement (sheet in position 2.c. of the table of contents), then
enter the following heading into column C and data in columns J – N of the following row:
Row Heading Data
18 Increase in Creditors =BS!J26-IF(J$7=1,OBS!$J18,BS!I26)
This formula calculates the increase in creditors in each period by subtracting the prior period creditors balance from
the current period creditors balance. In the first forecast period, the prior creditors debtors balance must be sourced
from the opening balance sheet, while in subsequent periods it is sourced from the balance sheet.
Ensure that this increase in creditors is included in cash payments by amending the formula in the cash payments
calculation cell J19 with the following formula, then copy and paste across the range J19:N19:
=SUM(J15:J18)
CREDITORS

After doing this, cash payments
should equal $206,479m in FY21
and increase to $271,538m in FY25,
and the balance sheet should
balance, as shown here:
CREDITORS Cash Flow Statement – Increase in Creditors

Note that the balance sheet now
balances because the movement in
creditors on the balance sheet in
each period is offset by a
corresponding cash adjustment in
the cash flow statement, which flows
through to net assets via cash.
Now that the cash payments sub-
section of the cash flow statement is
complete, group and collapse rows
15 – 18 to hide the cash payments
detail rows by default, as shown
here:
The Apple financial model now
contains debtors, inventory, and
creditors on the balance sheet, and
the necessary working capital
adjustments to calculate cash
receipts and cash payments on the
cash flow statement.
CREDITORS
Cash Flow Statement – Cash Payments

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