Working capital and cash flow are two of the most fundamental concepts of financial analysis. Working capital is associated with the balance sheet on a company's financial statement whereas cash flow is associated with the cash flow statement of a company's financial statement.
As the different sections of a financial statement impact one another, changes in working capital affect the cash flow of a company. To find out how, it's important to understand the components themselves.
Key Takeaways
- Working capital is the difference between a firm's current assets and current liabilities, represented on the balance sheet.
- Working capital represents the amount of money a company has to pay its short-term obligations.
- Cash flow is the net amount of cash and cash equivalents coming in and out of a company and is represented on the cash flow statement.
- A positive cash flow indicates a company has enough money coming in to reinvest in the business, pay down debt, return money to shareholders, and withstand financial challenges.
Working Capital
Working capital represents the difference between a firm’s current assets and current liabilities.Working capital, also called net working capital, isthe amount of money a company has available to pay its short-term expenses.
Positive working capital is when a company has more current assets than current liabilities, meaning that thecompany can fully cover its short-term liabilities as they come due in the next 12 months. Positive working capitalis a sign offinancial strength; however, having anexcessive amount of working capital for a long time might indicate that the company is not managing its assets effectively.
Current assets are any assets that can be converted to cash in 12 months or less. Current liabilities are obligations that come due in 12 months or less.
Negative working capital is when current liabilities exceed current assets, and working capital is negative. Working capital couldbetemporarily negative ifthe company had a large cash outlayas a result of a large purchase of products and services from its vendors.
However, if the working capital is negative for an extended period of time, it may be a cause for concern for certain types of companies, indicating that they are struggling to make ends meet and have to rely on borrowing or stock issuances to finance their working capital.
Cash Flow
Cash Flowis the net amount of cash and cash-equivalents being transferred inand out of a company.
Positive cash flow indicates that a company's liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses, and provide a buffer against future financial challenges.
Negative cash flow can occur ifoperating activities don'tgenerate enough cash to stay liquid. This can happen if profits are tied up in accounts receivable and inventory. It can also happen if a company spends too much on capital expenditures. Retailers must tie up large portions of their working capital in inventory as they prepare for future sales.
Understanding thecash flow statement, which reports operating cash flow, investing cash flow, and financing cash flow, is essential for assessing a company’sliquidity, flexibility, and overall financial performance.
HowWorking Capital Impacts Cash Flow
Changes in working capital are reflected in a firm’s cash flow statement. Here are some examples of how cashand working capital can be impacted.
If a transaction increases current assets and current liabilities by the same amount, there would beno change in working capital. For example, if a company received cash fromshort-term debt to be paid in 60 days, there would beanincrease in the cashflow statement; however, there would be no increase in working capitalbecause the proceeds from the loan would be a current asset or cash, and the note payable would be a current liability since it's a short-term loan.
- If a company purchaseda fixed asset such as a building, the company's cash flow would decrease. The company's working capital would also decrease since the cash portion ofcurrent assets wouldbe reduced, butcurrent liabilities would remain unchanged because it would belong-term debt.
- Conversely, selling a fixed asset would boost cash flow and workingcapital.
- If a companypurchased inventory with cash, there would be no change in working capital because inventory and cash are both current assets; however, cash flow would be reduced by inventory purchases.
Example of Working Capital and Cash Flow
Below is Exxon Mobil's (XOM) balance sheet from the company'sannual report for 2022. We can see current assets of$97.6 billion and current liabilities of $69 billion.
- Cash and cash equivalents is $29.6 billion, and materials and supplies is $4 billion.
- If Exxon decided to spend an additional $3 billion to purchase inventory, cash would be reduced by $3 billion,but materials and supplies would be increased by $3 billion to$7 billion.
- There would be no change in working capital, but operating cash flow would decrease by$3 billion.
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Imagine if Exxon borrowed an additional $20 billion in long-term debt,boosting the current amount of $40.6 billion to $60.6 billion. Cash flow would increase by $20 billion. Working capital would also increase by$20 billion. The amount would be added to current assets without any debt added to current liabilities; sincecurrent liabilities are short-term, one year or less, and the $40.6 billion in debt is long-term.
What Is the Relationship Between Working Capital and Cash Flow?
Working capital is a snapshot of a company's current financial condition—its ability to pay its current financial obligations. Cash flow looks at all income and expenses coming in and out of the company over a specified time period, providing you with the big picture of inflows and outflows.
How Does an Increase in Working Capital Affect Cash Flow?
An increase in a company's working capital decreases a company's cash flow. When you determine the cash flow that is available for investors, you must remove the portion that is invested in the business through working capital.
What Is the Formula for Cash Flow?
The formula for operating cash flow is Operating Cash Flow = Operating Income + Non-Cash Expenses - Taxes + Changes in Working Capital.
The Bottom Line
Acompany’s working capital is a core part of funding its daily operations; however, it's important to analyze both the working capital andthe cash flow of a company to determine whether the financial activity is a short-term or long-term event.
A boost incash flow and working capital might not be good if the company istakingon long-term debt that doesn't generate enough cash flow to pay it off. Conversely, a large decrease in cash flow and working capital might not be so badif the company is usingthe proceeds toinvestin long-term fixed assets that will generate earningsin the years to come.
