Understanding Working Capital and Cash Flow

Working capital and cash flow are two of the most important concepts in financial analysis. And financing is a major component of large and small businesses.

Two important aspects of business financing – cash flow and working capital – are crucial to the viability of a business.

Although the two concepts are similar, they are different. What is the difference between working capital and cash flow? 

Working capital is related to the balance sheet of a company’s financial statements, while cash flow is derived from the cash flow statement of a company’s financial statements.

Since the different areas of a financial statement affect each other, changes in working capital affect a company’s cash flow. To figure out the connection, it is important to understand the components themselves.

The working capital

Working capital represents the difference between a company’s current assets and its current liabilities. Working capital, also called net working capital, is the amount a company has available to pay its current liabilities.

Positive working capital is when a company has more current assets than current liabilities, which means that the company will be able to fully cover its current liabilities as they come due in the next 12 months. 

Positive working capital is a sign of financial strength. However, if the company has excessive working capital for an extended period of time, this may indicate that the company is not managing its assets effectively.

Negative working capital is when current liabilities exceed current assets and working capital is negative. Working capital could be temporarily negative if the company had high liabilities as a result of a large purchase of products and services from its suppliers.

However, if working capital is negative for a longer period of time, this can be a cause for concern for certain types of companies. This suggests that they are struggling to make ends meet and are relying on borrowing (debt) or equity to finance their working capital.

The cash flow

Cash flow is the net amount of cash and cash equivalents transferred into and out of a business.

A positive cash flow indicates that a company’s cash and cash equivalents are increasing. It can repay liabilities, reinvest in the business, make distributions to shareholders, pay bills, and build a buffer for future financial challenges.

Negative cash flow can occur when the company’s operating activities do not generate enough cash to remain liquid. This can happen when profits are tied up in receivables and inventory, or when a company spends too much on capital expenditures.

Understanding the cash flow statement, which shows operating cash flow, cash flow from investments and cash flow from financing, is essential for assessing a company’s liquidity, flexibility and overall financial performance.

How working capital affects cash flow

Changes in working capital are reflected in a company’s cash flow statement

Here are some examples of how cash flow and working capital can be affected.

  • If a transaction increases current assets and current liabilities by the same amount, there is no change in working capital. For example, if a company received cash from current liabilities payable within 60 days, there would be an increase in the cash flow statement.

However, there would be no increase in working capital. The payment from the loan flows into a current asset or cash item and the offsetting item paying is a current liability because it is a short-term loan.

  • If a company buys a fixed asset item such as a building, the company’s cash flow would decrease. The company’s working capital would also decrease as the cash portion of the current assets would be reduced, but the current liabilities would remain unchanged as it would be a long-term loan.
  • Conversely, the sale of a fixed asset would increase cash flow and working capital.
  • If a company were to buy inventory with cash, there would be no change in working capital as both inventory and cash are current assets. However, cash flow would be reduced by the purchase of inventory. 

How to calculate working capital?

There are several different methods for calculating net working capital, depending on what the analyst wants to include or exclude in the value.

Formula 1: Net Working Capital = Current Assets (less cash) – Current Liabilities (less debt)

Formula 2: Net Working Capital = Current Assets – Current Liabilities

Formula 3: Net Working Capital = Accounts Receivable + Inventory – Accounts Payable

The bottom line

A company’s working capital is a core component of financing its operations. However, it is important to analyse both a company’s working capital and cash flow to determine whether financial activity is a short-term or long-term event.

An increase in cash flow and working capital may not be good if the company is taking on long-term debt but not using it in a way that generates enough cash flow to service the repayment. 

Conversely, a large decrease in cash flow and working capital might not be so bad if the company uses the proceeds to invest in long-term assets that will generate profits in future years.

If you have any questions about this topic, contact our tax advisors in Barcelona by telephone or email. Either you are a small or big company, we can advise you on these matters.

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