Negative operating working capital does not automatically mean a DCF error. What enters free cash flow is the change in operating working capital. If it becomes more negative, that change releases cash under the model’s assumptions; if it becomes less negative, it consumes cash.
Define the balance before calculating the change
For this fictional example, operating working capital equals accounts receivable plus inventory minus accounts payable and deferred revenue. Exclude cash and interest-bearing debt. Real models can include other operating current assets and liabilities, so define your accounts consistently.
| Item | Year 0 | Year 1 |
|---|---|---|
| Receivables | 20 | 24 |
| Inventory | 10 | 12 |
| Payables | (25) | (30) |
| Deferred revenue | (15) | (18) |
| Operating working capital | (10) | (12) |
The change is −12 − (−10) = −2. In unlevered free cash flow, subtracting that change adds $2. If after-tax operating profit is $30, depreciation $5 and capital expenditure $8, free cash flow is 30 + 5 − 8 − (−2) = 29.
Reverse the operating direction
Suppose the following year the business contracts and the working-capital balance returns from −12 to −10. The change is now +2. Holding the other inputs constant only to isolate this effect, free cash flow becomes 30 + 5 − 8 − 2 = 25.
That $4 swing is not a contradiction. Growth previously brought additional supplier or customer funding; contraction reverses some of it. In a full forecast, operating profit and capital expenditure would probably change too.
Check whether the funding persists
Ask what produces the negative balance. Customer prepayments differ from overdue supplier bills. One may reflect the business model; the other may signal payment stress. Look at contractual timing, seasonality, revenue recognition and whether unusually long payment terms can continue.
Damodaran’s working-capital discussion cautions against treating continued releases as an unlimited source of value. The numerical example here is original and is not a forecast for a real company.
For terminal value, test a stable operating balance tied to the business’s mature economics. A large perpetual release deserves scrutiny; do not extend a one-time improvement forever. A deferred-revenue balance also does not mean all customer cash is free to distribute: the company still has service obligations.
Interview answer and next drill
“I would check the definition and the change. In my example, working capital moves from negative $10 to negative $12, releasing $2 of cash. I would then test whether supplier terms or customer prepayments support that funding in a mature business.”
Return to the DCF interview guide for the full model. Then use the terminal-value cross-check to see whether a favorable cash-conversion assumption is driving an implausible exit value.