Why Do You Subtract the Change in Net Working Capital?

Net working capital, the difference between a company’s current assets and liabilities, measures its short-term financial health and operational liquidity. This metric indicates the funds available for day-to-day operations and a company’s ability to meet its short-term obligations.

Maintaining adequate net working capital is important for a company’s smooth functioning. It ensures there is enough cash or easily convertible assets to cover immediate expenses and liabilities, preventing potential liquidity issues. Understanding how changes in this metric impact cash flow provides insights into a company’s true financial performance.

Understanding Net Working Capital

Net working capital (NWC) is calculated by subtracting current liabilities from current assets. Current assets are resources a company expects to convert into cash, sell, or consume within one year. Examples include cash and cash equivalents, accounts receivable (money owed by customers), inventory, and prepaid expenses.

Current liabilities are obligations a company expects to settle within one year. Examples include accounts payable (money owed to suppliers), accrued expenses (like unpaid wages), and the current portion of long-term debt. A positive NWC indicates a company has enough short-term assets to cover its short-term debts, suggesting financial flexibility.

Conversely, negative NWC means current liabilities exceed current assets, potentially signaling liquidity challenges. The “change in net working capital” is the difference between the NWC at the end of a reporting period and the NWC at the beginning of that period.

The Mechanics of Subtracting Changes in Working Capital for Cash Flow from Operations

Companies use accrual accounting to prepare their income statements, which recognizes revenues when earned and expenses when incurred, regardless of when cash changes hands. To understand a company’s actual cash generation from its core business, financial statements convert net income from an accrual basis to a cash basis through the Cash Flow Statement. The indirect method, commonly used for this conversion, starts with net income and adjusts for non-cash items and changes in working capital.

An increase in a current asset, other than cash, indicates that cash has been used or not yet received, thus reducing cash flow. For instance, if accounts receivable increases, it means the company has made sales on credit but has not yet collected the cash from customers. This ties up cash that could otherwise be available, so the increase in accounts receivable is subtracted from net income to reflect this cash outflow. Similarly, an increase in inventory means cash was spent to acquire more goods, which is a cash outflow and is also subtracted.

Conversely, an increase in a current liability indicates that an expense was incurred but not yet paid in cash, effectively conserving cash. For example, if accounts payable increases, the company has purchased goods or services on credit but has not yet paid its suppliers. This defers a cash outflow, so the increase in accounts payable is added back to net income. A decrease in a current asset, such as a reduction in inventory, implies cash was freed up, which is added back to net income. A decrease in a current liability, like a reduction in accounts payable, means cash was used to pay off obligations, which is subtracted from net income.

The Impact of Changes in Working Capital on Free Cash Flow Calculation

Free Cash Flow (FCF) measures the cash a company generates after covering its operating expenses and making necessary investments in capital assets. It represents the cash available to all capital providers, including debt and equity holders. Calculating FCF often begins with Net Operating Profit After Taxes (NOPAT) or Cash Flow from Operations (CFO), and similar to CFO, it requires adjustments for changes in net working capital.

The reason for adjusting FCF for changes in net working capital is consistent with the adjustments made for Cash Flow from Operations: to accurately reflect the cash tied up or released by a company’s day-to-day operations. For example, if a company is expanding rapidly, it may need to invest more in working capital, such as increasing its inventory levels or extending more credit to customers, which ties up cash. This increase in working capital reduces the cash available as FCF.

Conversely, efficient management of working capital, such as collecting accounts receivable faster or delaying payments to suppliers, can free up cash. This decrease in working capital increases FCF, as more cash becomes available for other purposes. Therefore, including changes in net working capital in the FCF calculation provides a more complete picture of a company’s ability to generate discretionary cash for growth, dividends, or debt reduction.