Buffett's owner earnings and working capital

[ratiman]

Buffett gave his well-known definition of owner earnings:

 

Owner earnings = Net income + depreciation & amortization +/- one-time items +/- changes in working capital – capital expenditures \

 

 

What's interesting to me is that he subtracts "changes in working capital" to get owner earnings. He explains it this way:

 

"If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in [the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.]"

 

 

OK, so working capital is equivalent to capex. But what if the business borrows from a bank at 2% interest to fund working capital? It would be hard to borrow against the full value of a truck at 2%, but banks will lend against receivables at 2%, I think. So there does appear to be a difference between working capital and capex. Buffett said that the auto dealership business because is attractive in part because the inventory can be easily borrowed against (or cheaply funded), so he seems to make the same distinction. 

 

So my question is whether it really makes sense to subtract working capital to calculate owner earnings and whether it should be treated as equivalent to capex.

 

[rb]

Short answer: Yes.

 

It's capital that needs to go into the business. Just like CapEx. The financing rate doesn't matter. Let's invert it: if a company has a high credit rating and borrows long term at 2% to build a factory should we not count that as CapEx just because the rate is low?

[ratiman]

Short answer: Yes.

 

It's capital that needs to go into the business. Just like CapEx. The financing rate doesn't matter. Let's invert it: if a company has a high credit rating and borrows long term at 2% to build a factory should we not count that as CapEx just because the rate is low?

 

All else being equal, it's not possible to fund capex and working capital at same rate. 

 

A company with high working capital needs (like a distributor) is going to have lower borrowing costs than a company that invests an equivalent amount in capex (investing in factories). Assuming that distinction away doesn't help answer the question.

 

 

[rb]

Ratiman,

 

I wrote my first reply quickly and I wasn't very thorough cause I was running late for a meeting. For that I apologize.

 

That being said the equation is still good. A couple of points:

 

I see that you're more concerned about financing rates. That short term assets like receivables and inventories can be financed at lower rates. That indeed creates some value. But the formula accounts for that. If your interest costs are lower because you have more current assets then your NI is higher and that boosts owner earnings.

 

You will also notice that interest is an income sheets item hence it's representation in the formula through NI. Change in WC is a balance sheet item so it has nothing to do with interest. Let's think simply of WC as current assets-current liabilities. Let's say that your business increases AR by $100 then finances $90 of that with a factoring loan. Then WC went up by $10. That money is not financed, it's equity. Basically money that you as the owner can't take out of the business - therefore it reduces your owner earnings. Notice that that $10 is unaffected by what interest you pay on the 90.

 

I hope this helps more than my previous reply.