How do changes in working capital affect cash flow in DCF?

In a Discounted Cash Flow (DCF) analysis, changes in working capital directly affect cash flow because they represent the short-term financial health and operational efficiency of a business. When working capital increases, it typically means that a company has invested more in current assets, such as inventory or accounts receivable, which ties up cash. For example, if a company increases its inventory levels to prepare for anticipated sales, it will require cash to purchase that inventory, resulting in cash outflows. This increase in working capital can therefore lead to a reduction in available cash flow, impacting the overall valuation in a DCF model.

It is important to consider that while working capital changes are necessary for growth and operations, they also can represent cash that is not immediately available for other uses, such as reinvestment or distribution to shareholders. Thus, the acknowledgment that increased working capital necessitates cash outflows aligns with how cash is managed in financial projections.