In finance, there is a clear distinction being made between accounting earnings and actual cash flows. In order to calculate a firm’s cash flows, one of the components that need to be subtracted from its earnings is the change in working capital. The reason for that is the fact that if a business decreases or increases its WC, it would result in a total cash increase or decrease to the firm.
That concept might be difficult to understand for someone who isn’t familiar with or has heard of working capital for the first time. The following article will hopefully clarify the 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 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 a formula is not exactly the same as understanding it. We could only remember this formula and might be able to calculate changes in working capital for different purposes in seconds but we would still not understand what working capital actually is and why it exists.
So what exactly are current assets and liabilities? And why do we specifically look at them out of all the items on a firm’s balance sheet in order to calculate working capital?
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 considered as current assets minus current liabilities would be by illustrating a simple example.
Example: Modern Shoes Co.
Let’s suppose that a young manufacturing company called Modern Shoes Co. is about to start 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 produced most of their sneakers (by using all of their inventory) which are now available for sale.
A retailer agrees to buy all of Modern Mechanics’ finished shoes on credit for $80 million. The business now has $80 million in expected cash to receive in the future which is why it’s called accounts receivable. As soon as the cash comes in, the firm will eventually be able to use it in order to buy even more inventory again which enables them to produce even more amounts of products that can be sold.
What we can notice in our example is that cash, inventory, and accounts receivable are all constantly in motion and moving within a cycle. Assuming that all things go well, that cycle hopefully repeats itself and grows bigger with each repetition as the company’s operations continue.
Since the amount of capital invested into that cycle is constantly working, it might as well be described as working capital. However, Modern Shoes could also take the option to buy additional inventory with credit as well (creating a current liability).
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.
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 an Increase in WC Is a Cash Outflow
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:
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.