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Financial Modeling 101: Part II - Balance Sheet, Working Capital and Cash Flow Items
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Excel File Shown In Video Is Available In Part III
In Part I - Revenue and Income Statement Build-Up we discussed creating drivers for future revenue of NVIDIA and how to calculate operating and non-operating expenses as a function of revenue or driven by other factors.
Revenue and costs are recognized based on revenue recognition accounting rules. But often there is a timing mismatch between when items are revenue is recognized or costs expensed on the income statement and when cash goes in or out the door. Those differences are picked up in the balance sheet and cash flow statement as asset and liability line items and changes in those line items.
Balance Sheet, Working Capital and Cash Flow Items
Working capital is current assets less current liabilities. It is cash that is consumed or produced by the balance sheet rather than income statement. Cash flow before working capital (also known as Funds From Operations, or "FFO") tells you how much cash the business generated in any one period whereas cash from operations ("CFO") equals FFO plus or minus the change in working capital.
Using historical metrics as a guide post for reasonable future assumptions, we can use income statement and balance sheet line items to calculate three important working capital items for the balance sheet:
Accounts Receivable ("AR") Turnover = revenue divided by accounts receivable
AR Days = 365 / AR Turnover
AR = revenue recognized but unpaid
Higher AR is a USE OF CASH and lower AR produces cash
Accounts Payable ("AP") Turnover = cost of revenue divided by accounts payable
Days Payable = 365 / AR Turnover
AP = expensed but unpaid costs
Higher Payables PRODUCE cash while the opposite is true
Inventory Turnover = costs of revenue divided by inventory
Inventory days = 365 / Inventory Turnover
Inventory = goods and materials that will be converted into revenue
Like receivables, higher inventory uses cash - it is the case that higher current liabilities generate a working capital benefit, whereas higher current liabilities produce cash
Additional current asset or liability line items can be calculated as a percentage of revenue
Prepaid expenses and other current assets
Accrued and other current liabilities
Other current liabilities
Once calculations are done to produce all needed working capital line items on the balance sheet, the differences between the current and prior year can be calculated to show the cash flow statement impact of those changes
Using historical data and prior year net plant, property and equipment ("PP&E"), together with capital expenditures ("Capex") assumptions, and depreciation and amortization ("D&A") from the cash flow statement, future PP&E and D&A can be derived
Historical net PP&E divided historical D&A = average remaining life of PP&E
Capex is calculated as a % of revenue
D&A = beginning PP&E divided by average remaining life + a partial period of depreciation current year Capex
Beginning PP&E + Capex - D&A = Ending PP&A (tie to balance sheet)
Street estimates for Capex can be used as a reasonableness check
We can now start to build the cash flow statement
Net income (+)
D&A (+)
Stock compensation (+)
Deferred taxes (+/-)
Other non-cash charges(+/-)
Change in working capital (+/-)
= Cash from operations
Capex = investing cash flow
Margin expansion can be seen in scaling metrics (revenue growing faster than costs), but ultimately also shows up as cash flow margin (FFO) expansion. Think of FFO margin like this: for every $1 in revenue, how much cash does the business generate. The improving cash flow NViDIA has seen in recent years was foreseen in 2015.
Unidentified Participant So assuming that the revenue continues to grow at a healthy clip and the team continues to drive an OpEx growth that is lower than the revenue growth, obviously that still paints a picture of margin expansion. We have the team delivering low 20% operating margins this calendar year. Longer term where can the upper end of the operating margin spectrum be?
Reference Materials
Balance sheet
Cash flow statement
PP&E table
Accrued and other current liabilities table