In finance, there is a clear distinction being made between accounting earnings and actual cash flows. Earnings are also known as net income: They represent what a company has earned on their revenues over a measured time period after subtracting all the associated costs, operating costs and financial expenses to arrive at the bottom line of every company’s income statement.
We can further observe that net income figure at the start of every company’s cash flow statement. From there, certain adjustments are being added and subtracted in order to arrive at the actual operating cash flows of the company. One of those key components that need to be considered when deriving cash flows is working capital.
The concept of working capital and how it affects cash flows might be difficult to grasp for someone who isn’t familiar with, or has heard of working capital for the first time. The following article will hopefully clarify the basic mechanics of a firm’s working capital and thus provide answers to questions such as why an increase in WC would be a cash outflow.
What’s the Change in WC?
The change in working capital is the difference between a company’s current working capital and its working capital from the previous accounting period. Since we calculate the difference by subtracting the previous WC from the current WC, that change can either be positive (increase in WC) or negative (decrease in WC).
Why Is an Increase in WC a Cash Outflow?
An increase in working capital requires a company to use more capital to either increase its current assets (e.g. buying additional inventory) or decrease its current liabilities (e.g. paying off accounts payable). Both actions represent cash outflows.
The best way to quickly illustrate what a change in working capital really is would be to use inventory as the primary example.
Let’s suppose that company A currently had $30 million worth of inventory in form of raw materials, and already produced goods. Its management decides to increase inventory with the purchase of additional raw materials worth $20 million in order to enhance production. The total inventory that company A would now have is $50 million as stated in the table below:
Assets | Previous Period | Current Period |
Inventory | $30 million | $50 million |
Now, if we ask ourselves what exactly led to the increase in inventory of $20 million, the answer would obviously be the amount of cash that the business had to spent to purchase it. In other words, that increase reflects a cash outflow which is also why changes in working capital essentially represent amounts of cash that the business had to spend/miss out on or cash that the firm received.
Inventory is only one of the several types of current assets that every business has. But the same principle applies to the other current assets as well: An increase in accounts receivable would also represent a cash outflow as it essentially reflects the increasing amount of cash somebody else owes the firm. Cash that is owed hasn’t been received by the company yet and thus doesn’t increase cash flows.
What’s Working Capital Exactly?
By most definitions, the change in working capital is the difference between a firm’s current working capital and its previous working capital:
Whereas working capital is defined as a firm’s current assets minus its current liabilities:
The formula for working capital is pretty straightforward. But merely memorizing it is not the same as understanding it. So what exactly are current assets and liabilities? And why do we specifically look for them out of all the items on a firm’s balance sheet in order to compute working capital?
Current assets include all the assets of a firm that are expected to be converted into cash within a 12-month period. Classic examples for current assets are cash, inventory, and accounts receivable.
Current liabilities, on the other hand, represent any short-term obligations that a business has to meet within a 12-month period. Accounts payable is a typical current liability: When a firm decides to buy additional inventory on credit, for instance, the amount of money that the firm owes to the supplier would appear as accounts payable. Other current liabilities include accrued expenses and unearned revenue.
The best way to show why working capital is defined as current assets minus current liabilities would be by illustrating a simple example.
Example: Modern Shoes Co.
Let’s suppose that a young apparel manufacturer called Modern Shoes Co. is about to launch its business operations. The firm gets going with a cash balance of $100 million that it was able to raise through equity.
Modern Mechanics decides to spend $50 million of its cash to buy raw materials that they need to produce their first line of urban sneakers. Their current assets now consist of $50 million in cash and another $50 million in inventory. After some time, the business has used up all of their inventory to produce a variety of different sneakers which are now available for sale.
A retailer agrees to buy all of the finished sneakers on credit for $80 million: Modern Shoes Co. now has $80 million in expected cash to receive in the future which is why those $80 million are referred to as accounts receivable. As soon as the payments from the retailer have been received, the firm will eventually be able to use it in order to buy more inventory again which enables them to produce even more amounts of products that can be sold.
What we can notice in the example is that cash, inventory, and accounts receivable are all constantly in motion and moving within a cycle (cash -> inventory -> accounts receivable -> cash). Assuming that all things go well, that cycle hopefully repeats itself and grows bigger with each repetition as the company continues to operate.
Since the amount of capital invested into that cycle is constantly working, we might as well described it as working capital. However, there are many additional components that can affect the cycle of working capital as well. For instance, Modern Shoes could also use the option to buy additional inventory on credit which would create a current liability on the company’s balance sheet.
But because we only want to account for the net amount of capital that is working within the business, we would have to subtract out the effects of current liabilities. That finally leads us to the general definition of working capital mentioned above: WC = Current assets – Current liabilities
This is also the reason why some people refer to working capital as net working capital (NWC) instead.
Conclusion
- Working capital represents the net portion of a firm’s capital that is constantly in motion in order for the business to run its operations.
- A change in working capital from one period to another either reflects a cash inflow or outflow, depending on whether that change was positive or negative.
- If a company wants to increase its working capital, it will have to deploy additional capital (to increase its current assets) or use capital to pay off short-term obligations (to decrease current liabilities). Both types of actions represent cash outflows.
