If you’re calculating a firm’s free cash flow to figure out its valuation, you may be wondering why changes in working capital are a cash flow.
An increase in net working capital means a cash outflow because it indicates the company granted more credit to customers and spent more on inventories to increase them, reducing the cash available.
Let’s dive deeper to understand cash flow vs working capital:
What is Working Capital
Working capital is the difference between a company’s current assets and current liabilities. These are categories present in the balance sheet.
Current assets are either cash or assets that can be converted into cash within a year. These are mostly liquid financial securities, money clients owe you (accounts receivable), and inventories of products and raw materials.
Current liabilities are debts that will be satisfied within a year. Money you owe suppliers for products and services (accounts payable) and short-term bank loans are the major components of this category.
The working capital formula is the following:
Working Capital = Current Assets – Current Liabilities
An alternative formula focuses solely on balances related to day-to-day business operations. Excluding cash and debt, key components of net working capital (NWC) are accounts receivable, inventory, and accounts payable. You can also include working cash.
Net Working Capital = Accounts Receivable + Inventories – Accounts Payable
Now that you know what is net working capital, let’s go through what happens when this number increases:
Understanding an Increase in Working Capital
Given the formula above, in order for working capital to increase, current assets must increase and/or current liabilities decrease. This means one of these things:
- Increase in accounts receivable: The business sold more products and services for which the customers haven’t paid yet.
- Increase in inventories: This indicates the company purchased more goods than it sold.
- Decrease in accounts payable: The company transferred money to suppliers (cash outflow) to pay off the credit they gave it when buying raw materials and services.
All three can happen simultaneously, causing a substantial increase in NWC.
An increase in working capital means there’s more capital available to run the business in the short term.
However, this is only on paper. Customers can continue to not pay for inventories you already delivered to them for years, and those outstanding balances will never be converted into cash inflows.
It can also mean the company lacks negotiating power with its customers, as they don’t feel the need to pay off their debts in a timely fashion.
Now that you understand what causes an increase in working capital, let’s go through an overview of free cash flow. If working capital increases what happens to cash flow?
Understanding Free Cash Flow
Free cash flow (FCF) shows you how much liquidity a company is left with after operational activities. These cash flows can then be discounted at a certain rate to get their present value and evaluate the business. This is the Discounted Cash Flow (DCF) method used for capital budgeting.
Free cash flow is different from the cash flow statement, as the latter also looks at investing and financing activities. Working capital movements are mostly included in the operational section of the cash flow statement.
Starting with the net income of a business, if you want to calculate its free cash flow you must:
- Add back depreciation and amortization, as these do not represent actual money being transferred out of the company.
- Subtract capital expenditures, because these don’t show up in the income statement as an expense. (Only partially through depreciation.)
- Subtract changes in working capital, because an increase in working capital is a cash outflow, and a decrease is an inflow.
The last step is what we’re focused on.
Let’s see why is a change in net working capital a cash flow:
Why an Increase in Working Capital is a Cash Outflow
Now you’re in position to understand why does an increase in working capital decrease cash flow.
When calculating free cash flow, you adjust for changes to net working capital that arise from changes to accounts receivable, accounts payable, or inventory.
To understand this, remember some key details of the balance sheet and income statement:
When a company sells a product, it records the revenue as income even though it may not receive the cash from that sale immediately. Instead, it grants the customer credit and allows them to pay later. The customer’s obligation adds to the company’s accounts receivable. With this in mind, here’s how to adjust for changes in working capital:
- Accounts Receivable: When you record a sale as part of net income but the customer hasn’t paid you the cash yet, you must adjust the cash flows by deducting the increases in accounts receivable. Why? Because this increase represents additional lending by your company to its customers, reducing the cash available to the company.
- Accounts Payable: Opposed to this, you add increases in accounts payable. Accounts payable are borrowings the firm receives from its suppliers. This borrowing increases the cash available to the firm.
- Inventory: Finally, we deduct increases to inventory. Increases to inventory are not recorded as an expense in the income statement and do not contribute to net income. However, the cost of increasing inventory is a cash expense for the firm and must be deducted.
There you have it! This is why an increase in working capital means cash outflow.
On the other hand, a decrease in working capital means there’s more cash available to the firm because customers paid their debts, more inventories were sold, and suppliers gave the business more credit.
Frequently Asked Questions (FAQs)
Why is an increase in inventory a cash outflow?
Increases in inventory do not show up as an expense in the income statement. Since the purchase of additional inventory requires the use of cash, it means there was an additional outflow of cash. An outflow of cash has a negative effect on the company’s cash balance.
How does working capital affect cash flow?
Working capital is composed mainly of three balance sheet categories: Accounts receivable, accounts payable, and inventories. All three increase/decrease revenue and costs in the income statement, even though they are yet to be transformed into an actual positive or negative cash flow for the company. If you’re evaluating cash flows, you need to account for this.
Why is an increase in NWC a cash outflow?
An increase in working capital means cash outflow as the company has less cash available because it gave out more credit to customers, bought more inventory, and paid off debt to suppliers. As result, there’s less cash available. In contrast, a negative change in working capital means there’s more cash available for the firm.