What Changes in Working Capital Impact Cash Flow?

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.

Working Capital

Working capital represents the difference between a firm’s current assets and current liabilities. Current assets can be converted to cash in the short term and generally include:

• Cash and cash equivalents
• Marketable securities
• Accounts receivable
• Inventory

Current liabilities are debts due within the next 12 months and can include:

• Accounts payable
• Dividends owed
• Interest payable on outstanding debts
• Income taxes owed

Positive working capital is when a company has more current assets than current liabilities, meaning that the company can fully cover its short-term liabilities as they come due in the next 12 months. Positive working capital is a sign of financial strength; however, maintaining an excessive amount of working capital for an extended period may indicate that the company is not effectively managing its assets.

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 a large cash outlay as a result of a large purchase of products and services from its vendors.

However, if working capital remains negative for an extended period, it may be a cause for concern for certain types of companies, indicating that they are struggling to meet their financial obligations and must rely on borrowing or stock issuances to finance their working capital.

Cash Flow

Cash flow is the net amount of cash and cash equivalents being transferred in and 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 if operating activities don’t generate 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 the cash flow statement, which reports operating cash flow, investing cash flow, and financing cash flow, is essential for assessing a company’s liquidity, flexibility, and overall financial performance.

How Working Capital Impacts Cash Flow

Changes in working capital are reflected in a firm’s cash flow statement. Here are some examples of how cash and working capital can be impacted.

If a transaction increases current assets and current liabilities by the same amount, there would be no change in working capital. For example, if a company received cash from short-term debt to be paid in 60 days, there would be an increase in the cash flow statement; however, there would be no increase in working capital because 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 purchased a fixed asset such as a building, the company’s cash flow would decrease. The company’s working capital would also decrease because the cash portion of current assets would be reduced; however, current liabilities would remain unchanged, as the purchase would be financed through long-term debt. 
• Conversely, selling a fixed asset would boost cash flow and working capital.
• If a company purchased 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’s annual report for 2022. We can see current assets of $97.6 billion and current liabilities of $69 billion.

• Cash and cash equivalents were $29.6 billion, and materials and supplies were $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.

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; since current liabilities are short-term, one year or less, and the $40.6 billion in debt is long-term.

The Bottom Line

A company’s working capital is a core part of funding its daily operations; however, it’s important to analyze both the working capital and the cash flow of a company to determine whether the financial activity is a short-term or long-term event.

A boost in cash flow and working capital might not be good if the company is taking on 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 bad if the company is using the proceeds to invest in long-term fixed assets that will generate earnings in the years to come.