Let’s say that you want to calculate the free cash flow (FCF) of a particular company. After getting in touch with the formula of FCF, one of the first questions that might come up is why exactly we need to account for the change in working capital to derive a firm’s cash flow. In the following, we will clarify what working capital actually is and how any changes in working capital actually represent either cash inflows or outflows within a company.
What Is Working Capital?
So why exactly do people care about the change in a company’s working capital in the first place? And what role does it play in calculating real cash flows? In functional terms, working capital is commonly defined as the difference between a firm’s current assets and current liabilities:
Current assets are any assets that are expected to be converted into cash quickly (within one year), but it also includes assets that a business needs to deploy on an active basis in order to generate profits within one operating cycle. Primary examples of current assets are cash, inventory, and accounts receivable.
Current liabilities, on the other hand, are short-term financial obligations that a business has to fulfill either within a one-year time frame or an operating cycle. A common example of a current liability is accounts payable. That is money that a firm has yet to pay to suppliers for goods and services which have already been received.
The Operating Cycle
A simple way of getting behind the meaning of working capital is by imagining any firm’s current assets as little components of its operating cycle.
Let’s suppose that a small clothing business has managed to raise capital of $150,000 in form of cash to start its business venture. Cash is a current asset because of its liquidity but can be converted into other current assets as well: The business decides to use half of the cash to buy inventory in form of raw materials.
As a consequence, it now has $75,000 in cash and another $75,000 worth of inventory. The inventory is then used to produce goods that will be sold to customers. But the customers decide that they will mostly pay with credit instead of cash. Because of that, the company has some amounts of accounts receivables that also have to be recorded as current assets. After some months, the clothing store finally receives the cash payments from their customers.
This chain of events behaves like a cycle that continues to repeat itself throughout the time in which the business operates: Cash gets converted into inventory which then converts into accounts receivable, and then finally into (hopefully more) cash again.
Accounts payable is a liability because it represents a financial obligation that the business has yet to meet. Coming back to our example, let’s suppose that in our first operating cycle described above, the clothing business also had the opportunity to increase its inventory by $25,000 which it bought from a supplier on credit. As a consequence, it now has accounts payable of $25,000 that have taken place in the liability side of the firm’s balance sheet.
But due to the reason that we only want to analyze the company’s net amount of working capital, we would need to deduct the current liabilities from its current assets. As a consequence, working capital and net working capital are often used interchangeably while they both refer to the same thing.
How a Change of Working Capital Affects Cash Flows
A change of working capital is essentially defined as the difference between a firm’s current working capital relative to the amount of working capital in the previous accounting period:
It follows that the change in working capital can either be positive (when current WC is higher than previous WC) or negative (if current WC is lower than previous WC) which would consequently lead to an increase or decrease in free cash flow.
Why? Because when the difference between the current WC and the previous WC is positive, that increase could have only taken place as a consequence of a cash outflow.
On the other hand, if the difference is negative (meaning that previous working capital was higher than current working capital), the change in WC would be a cash inflow and thus increase total free cash flows.
The easiest way to explain why a positive change in WC is a cash outflow is to illustrate that with an example.
Increase in Inventory
Suppose that a manufacturing business had inventory worth $50 million in the previous year. But now, it wants to increase its inventory further with the goal to raise its production capabilities. Therefore, it buys an additional $25 million worth of inventory, resulting in a total inventory of $75 million in the current year:
The increase in inventory between year 1 and year 2 represents the money that the company spent to buy additional supplies. Buying supplies to increase inventory requires cash which is why that action is a cash outflow. For simplicity’s sake we only looked at inventory in this example but the same also applies to other current assets such as accounts receivable.
Decrease in Accounts Payable
A change in working capital can also be positive if the company decreased its current liabilities which would essentially mean that the business has paid back money (cash outflow) to reduce its short-term debt or accounts payable.
In our example, the manufacturing business previously had accounts payable of $25 million, because it initially had the opportunity to buy additional supplies with credit. Throughout year 2, the firm decides to pay off $10 million of the accounts payable:
Accounts payable decreased from year 1 to year 2 by $10 million and thus represents a cash outflow.
To summarize both examples again: When a business decides to increase its current assets or decrease its current liabilities, cash leaves the company which thus results in a decrease in cash flows.
Why the Change in WC Needs to Be Subtracted
The process of how a company calculates its operating cash flow starting from net income can be closely followed within a company’s cash flow statement. After that, the operating cash flow is then required to calculate free cash flow which has the following formula:
Any type of operational cash outflow needs to be subtracted from net income in order to arrive at free cash flow. The reason why we subtract out the change in working capital is the fact that we would either come up with a decrease in cash flows if the change is positive or an increase in cash flows if the change is negative.
For some types of businesses, the effect of working capital can make a considerable impact on how much the cash flows will actually differ from a company’s net income. Retail businesses, for instance, usually rely on high amounts of working capital to maintain constant operations and an efficient operating cycle. This emphasizes the importance and meaning of WC and why it is always necessary to account for the change in WC when looking at a firm’s cash flows.
Conclusion
- Working capital represents the net amount of capital that is used in a firm’s daily operations and is usually defined as the current assets minus current liabilities.
- The change in working capital is the difference between a firm’s current WC and its previous WC.
- That change can either be positive or negative. We subtract the change in WC from net income because a positive difference between new and old working capital would be a cash outflow, whereas a negative difference would be a cash inflow to the firm.
