How Changes in Working Capital Affect Cash Flow

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Changes in working capital are one of the main reasons a company’s operating cash flow differs from its net income. When non-cash working capital rises, because customers owe more, inventory builds up or suppliers are paid faster, cash is tied up and operating cash flow falls below profit. When non-cash working capital falls, cash is released and operating cash flow rises above profit. Under the indirect method, the cash flow statement records this as an adjustment: increases in current operating assets are subtracted, and increases in current operating liabilities are added.

The Basics

Working capital measures the short-term resources a company has available to meet short-term obligations. It comes from the balance sheet, so it is a snapshot at a single date:

Working capital = Current assets − Current liabilities

Current assets typically include:

• Cash and cash equivalents
• Marketable securities
• Accounts receivable
• Inventory
• Prepaid expenses

Current liabilities typically include:

• Accounts payable
• Accrued expenses, such as wages and interest payable
• Income taxes owed
• Dividends declared but not yet paid
• Short-term debt and the current portion of long-term debt

Positive working capital means the company could cover obligations due over the next year from assets expected to turn into cash in that period. A persistently large surplus, however, can mean idle cash or loosely managed inventory and receivables. Negative working capital can be temporary, after a large purchase from vendors, for example. If it persists, it can signal reliance on borrowing or issuing stock to fund day-to-day operations.

Cash flow, by contrast, measures cash moving in and out of a business over a period, reported in the operating, investing and financing sections of the cash flow statement. The change in working capital links the two. It is the difference between two balance sheet snapshots, and it appears as a line in the cash flow statement for the period between them.

How It Works

Why an increase in working capital reduces cash flow

Net income is calculated on an accrual basis. Revenue is recorded when it is earned, not when cash arrives, and expenses are recorded when they are incurred, not when they are paid. The working capital adjustment converts accrual profit back to cash.

• Accounts receivable rises: sales were booked as revenue but the cash has not been collected. Profit overstates cash, so the increase is subtracted.
• Inventory rises: cash went into goods that have not yet been sold and expensed. The increase is subtracted.
• Accounts payable rises: expenses were recorded but the supplier has not been paid. Profit understates cash, so the increase is added.
• Accrued expenses rise: the same logic applies. The cost hit income, but the cash has not left, so the increase is added.

The reverse holds for decreases. Collecting old receivables or selling down inventory releases cash, which is why a decrease in working capital counts as a cash inflow. Paying down payables consumes cash, so a decrease in payables is subtracted.

The “other working capital” or “other current assets and liabilities” lines on many cash flow statements follow the same rule. A positive number on one of these lines means those smaller items, taken together, released cash during the period (for example, accrued liabilities grew or prepaid expenses shrank). A negative number means they absorbed cash.

The formulas

Change in net working capital = NWC at end of period − NWC at start of period

For cash flow work, NWC is usually defined as operating current assets (excluding cash) minus operating current liabilities (excluding short-term debt). Cash is excluded because it is the result being explained, and short-term debt is excluded because borrowing and repaying it are financing activities.

Operating cash flow = Net income + Non-cash expenses − Increase in NWC

An equivalent version starts from operating income: operating income plus non-cash expenses (such as depreciation and amortization), minus taxes paid, minus the increase in working capital. If working capital decreased, the minus becomes a plus. This sign question is where most errors occur. “Change in working capital” as a balance sheet figure is positive when NWC grows, but the corresponding line on the cash flow statement is negative, because growth uses cash. Many cash flow statements present the line already signed as a cash effect, so a positive number there means working capital released cash.

Examples

All three examples are hypothetical and are meant to show the mechanics.

Example 1: Reconciling profit to operating cash flow

A company reports net income of $100,000 and depreciation of $20,000 for the year. Its balance sheet shows:

• Accounts receivable rose from $50,000 to $80,000 (+$30,000)
• Inventory fell from $40,000 to $35,000 (−$5,000)
• Accounts payable rose from $25,000 to $40,000 (+$15,000)

Operating cash flow = $100,000 + $20,000 − $30,000 + $5,000 + $15,000 = $110,000.

Net operating working capital rose by $10,000: assets increased by $25,000 and liabilities by $15,000. Subtracting that $10,000 from the $120,000 of profit plus depreciation gives the same $110,000. The company earned more than it collected, and slower collections absorbed more cash than the extra supplier credit provided.

Example 2: Transactions that move cash and working capital differently

The two measures do not always move together. Here is how common transactions affect total working capital (including cash) and the cash flow statement:

• Buying inventory with cash: Total working capital is unchanged, because one current asset is swapped for another. Operating cash flow falls, because the inventory increase is a use of cash in operations.
• Borrowing on a 60-day note: Cash rises, and so does a current liability, so total working capital is unchanged. The inflow appears in financing activities.
• Borrowing long-term debt: Cash rises with no new current liability, so total working capital increases. The inflow is a financing cash flow. Operating cash flow does not change.
• Buying equipment or a building with cash: Cash falls, so total working capital decreases. The outflow is an investing cash flow.
• Selling a fixed asset for cash: Total working capital and cash both rise. The inflow is an investing cash flow.
• Paying a supplier invoice: Cash and accounts payable fall by the same amount, so total working capital is unchanged. Operating cash flow falls, because payables decreased.

These cases explain why the simple rule “an increase in working capital decreases cash flow” applies to operating working capital. Total working capital can rise because the company raised cash through long-term debt, which increases cash flow.

Example 3: Working capital that grows with revenue

Suppose a business consistently carries receivables equal to 15% of annual revenue. Revenue grows from $1,000,000 to $1,400,000, so receivables grow from $150,000 to $210,000. That $60,000 increase is cash the company has not collected, even though every sale may be profitable.

This is why fast-growing companies can report rising profits and weak operating cash flow at the same time, and why analysts often forecast working capital as a percentage of revenue. Under that assumption, the change in NWC is the percentage multiplied by the change in revenue. The method works only as long as the ratio stays stable. Changes in credit terms, customer mix or inventory policy break the link.

Special Considerations

Working capital in a DCF

In a discounted cash flow model, free cash flow is commonly calculated as:

Free cash flow = EBIT × (1 − tax rate) + Depreciation and amortization − Capital expenditures − Increase in NWC

The increase in NWC is subtracted for the same reason capital expenditures are: money put into receivables and inventory is not available to investors. If NWC is forecast to shrink, the term adds to free cash flow. Because this line is projected for every forecast year, small changes to the assumed working capital ratio can noticeably shift a company’s estimated value.

Net working capital vs. the cash approach

Two methods reach the same operating cash figure. The net working capital approach (the indirect method) starts with net income and adjusts for non-cash items and working capital changes. The cash approach (the direct method) lists actual cash receipts from customers and cash payments to suppliers and employees. The indirect method shows where profit and cash diverge. The direct method shows the cash flows themselves. If both are prepared correctly, they produce the same operating cash flow.

Negative working capital vs. negative cash flow

Neither one is automatically good or bad, and they mean different things. Negative working capital can be a feature of a business model in which customers pay before the company must pay its suppliers. In that setup, growth can release cash rather than absorb it. Negative operating cash flow means the business consumed cash over the period. That can happen even when the business is profitable, as Example 3 shows. If it persists, the company has to fund operations through borrowing, equity or asset sales.

Reading the direction of a change

A large release of cash from working capital can flatter one period’s operating cash flow. Stretching supplier payments or cutting inventory frees cash once, but that cannot be repeated indefinitely. A large increase can be healthy if it supports sales the company will collect. Look at the trend across several periods instead of one year’s working capital line. A one-time inventory build before a product launch tells a different story than receivables rising faster than sales year after year.

The Bottom Line

Investors and analysts reconciling profit with cash, or building a DCF model, need to read the working capital line with its sign in mind. Growth in receivables and inventory can leave a profitable company short of cash, while a large one-time release can flatter a single year. Judging the trend across several periods gives a truer picture than any one year's figure.