Why might an investor need to adjust cash flows for working capital in a DCF?

Adjusting cash flows for working capital in a Discounted Cash Flow (DCF) analysis is crucial because it allows investors to align their cash flow estimates with operational cash flows. Working capital is essentially the difference between a company’s current assets and current liabilities, and it represents the liquidity available to the business for its day-to-day operations.

When an investor evaluates a company’s performance, it’s important to consider how changes in working capital affect cash flow. For example, if a company is increasing its inventory or accounts receivable significantly, its available cash might be reduced, which can impact operational cash flow. Adjusting for working capital ensures that the cash flows projected in the DCF model truly reflect the cash that is generated or consumed from operations, thus providing a more accurate assessment of the company's financial health and its ability to generate value for investors in the future. This adjustment helps ensure that the valuation is based on actual operational efficiency and liquidity, rather than just accounting measures that might not reflect the real cash position of the business.