One of the primary items that need to be deducted from net income in order to calculate the free cash flow for any given firm is the change in working capital. But what exactly is working capital and how does the change in WC affect cash flows?
What Is Working Capital?
In order to fully understand why we care about the change in working capital to calculate cash flows, we would first need to get behind the importance of working capital, to begin with.
In brief terms, working capital is mostly defined as the difference between current assets and current liabilities:
Current assets are any assets that are expected to be converted into cash within one year but also include assets that the business needs to actively deploy 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 (money that a firm has yet to pay to suppliers for goods and services that have already been received).
A simple way of getting behind the meaning of working capital is by imagining a firm’s current assets as components of an operating cycle.
Let’s assume that a young business has managed to raise capital of $150,000 in form of cash to start its business venture. Cash is a current asset 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.
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 who will mostly pay with credit. In other words, cash gets converted into inventory which then converts into accounts receivable, and then finally into (hopefully more) cash again.
This chain of events is like a cycle that continues to repeat itself throughout the time in which the business operates.
Since these current assets (cash, inventory, and accounts receivable) are constantly in motion, they would theoretically be called working capital. However, there are also current liabilities such as accounts payable that have to be taken into consideration.
Accounts payable is a liability because it represents a financial obligation that the business has yet to meet. Coming back to our example, the young business also had the opportunity to increase its inventory by $25,000 that it bought from a supplier on credit. As a consequence, it now has accounts payable of $25,000 that has 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
The 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 consequently leads to an increase or decrease in free cash flow.
In other words, when the difference between current working capital and previous working capital is positive, that change would be a cash outflow and thus lead to a decrease in free cash flow.
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 cash flows.
The easiest way to explain why a positive change in WC is a cash outflow and thus decreases cash flows is to illustrate the following example.
Let’s suppose that a manufacturing business (let’s call it company A) had inventory worth of $50 million in the previous year. Now, it wants to increase its inventory further with to 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, which is a cash outflow. We only use inventory in this example for simplicity’s sake but the same also applies to other current assets such as cash and accounts receivable.
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 money (cash outflow) to pay off short-term debt, or accounts payable.
In our example, company A previously had accounts payable of $25 million, because it had the opportunity to buy additional supplies with credit. The firm now pays off $10 million of the accounts payable:
The accounts payable decreased from year 1 to year 2 by $10 million and thus represent a cash outflow. To summarize, in both scenarios where a business decides to increase its current assets or decrease its current liabilities, cash leaves the company and 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. The operating cash flow is then needed 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.
- 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 out 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.