Working Capital
The capital tied up in a business’s short-term operating cycle: receivables plus inventory, minus payables. Changes in working capital are a key adjustment between EBITDA and free cash flow.
Behind the balance sheet · 3 of 17Next: Negative Working Capital
Working Capital · the mechanism
30 sec read
Say what an increase in working capital does to cash, and read the cash conversion cycle off a balance sheet.
Where it comes up. A director asks why a business growing 30% and printing a profit has just asked its lenders for more room.
Use the operating definition
Receivables plus inventory less payables. Not the textbook current assets less current liabilities, which includes cash and short-term debt. Those are financing items, and leaving them in makes the number meaningless for operations.
Get the sign right
An increase in working capital is a use of cash. You have funded more receivables or more inventory, or paid suppliers sooner. That is why it appears as a negative on the cash flow statement even though an asset went up on the balance sheet. This sign is where most candidates slip.
Read it as days
Days sales outstanding plus days inventory outstanding less days payable outstanding gives the cash conversion cycle: how long money is tied up between paying for something and being paid for it. Negative is a business funded by its own suppliers and customers, which is a genuine competitive advantage.
Worked through
A retailer: receivables 5 days, inventory 40 days, payables 60 days.
- Days sales outstanding
- 5
- Days inventory outstanding
- +40
- Days payable outstanding
- −60
A cash conversion cycle of minus 15 days. The business is paid by customers a fortnight before it pays suppliers, so growth generates cash instead of consuming it. This is the structural reason supermarkets and subscription businesses can grow without funding.
Check yourselfA fast-growing business is profitable and running out of cash. What is the most likely explanation?
Answer once you have one →
Working capital is absorbing it. Growth means funding more inventory and more receivables before the corresponding cash arrives, and if the cycle is positive, every extra pound of revenue consumes cash. Profit and cash diverge exactly here, and it is the most common way a healthy-looking company fails.
Be able to say this back next week
- Used receivables plus inventory less payables, not current assets less current liabilities
- Got the sign right: an increase is a use of cash
- Read the cycle in days, and said what a negative cycle means
Where working capital sits in the three statements
- Cash: −£10m
- Receivables: +£10m
- Change in working capital: −£10m
What moving it does
Receivables rise by £10m over the year with revenue, costs and profit exactly where they were: the same sales, collected more slowly.
| Statement | Line | Effect |
|---|---|---|
| Income statement | Every line | Nothing. Revenue was recognised when the goods went out; collecting later does not change what was earned. |
| Cash flow statement | Change in working capital | −£10m. The cash flow statement starts from net income, which counted the £10m as earned, and has to take it back out because it has not arrived. |
| Cash flow statement | Cash from operations | −£10m against the year before, on identical profit. |
| Balance sheet | Receivables | +£10m, an asset. |
| Balance sheet | Cash | −£10m, the same amount, because the money that would have been in the bank is owed instead. |
The close. Assets moved £10m from one line to another and total assets are unchanged, which is why nothing on the other side needs to move: equity is the same because profit is the same. That is the whole lesson in one row. Profit did not change, cash did, and the balance sheet shows where it went.
What the footnote discloses
In the note
- The ageing of receivables: how much is under 30 days, 30 to 90, over 90, and how much is provided against.
- Inventory by type (raw materials, work in progress, finished goods) and any write-downs to net realisable value in the period.
- Supplier finance arrangements, which IAS 7 and ASC 470-10 now require to be disclosed: payables that a bank has paid on the company’s behalf sit inside trade payables and look like free credit.
- Factoring or receivables sold, which take receivables off the balance sheet and flatter the cycle.
What an analyst does with it
- Compute days on each line (DSO, DIO, DPO) from the note rather than from the face of the balance sheet, and read the trend against revenue growth: receivables growing faster than sales is the earliest sign of channel stuffing or a customer in trouble.
- Move supplier finance out of payables and into debt before computing net debt and the cash conversion cycle. A stretched DPO funded by a bank is borrowing, not bargaining power.
- In a deal, build the working capital peg from twelve monthly balance sheets, not the year end, which is the single least representative day of the year for most businesses.
- Take the provision movement out of the year’s change: a release of a bad-debt provision is profit, not collection.
The interview question it becomes
- “Receivables go up by £10m. Walk me through the three statements.”
- Income statement: no change, the revenue was already recognised. Cash flow: the increase in receivables is a £10m use of cash inside the change in working capital, so cash from operations falls by £10m. Balance sheet: receivables up £10m, cash down £10m, total assets unchanged, so nothing on the liabilities and equity side moves.
- The follow-up: “And if it had been payables going up by £10m instead?”
- The sign flips and people follow the receivables answer by reflex. A rise in payables is a source of cash: the company has used £10m of goods or services and not yet paid for them, so cash from operations is £10m higher, cash up £10m on the asset side, payables up £10m on the liability side. The check is always the same question: did the company hand over cash, or hold on to it?
Why Working Capital matters in interviews
Working capital is where accounting meets cash, and interviewers use it to check that you know profit and cash are different things. It also runs straight into deal mechanics — the working capital adjustment is one of the most negotiated items in any purchase agreement.
How it works in practice
Operating net working capital = accounts receivable + inventory − accounts payable. The financing items (cash and short-term debt) are excluded, because working capital is meant to measure the operating cycle.
An increase in working capital consumes cash: you have shipped goods and not been paid, or bought stock you have not sold. That is why the change in working capital is subtracted in a free cash flow build.
A growing business with 60-day receivables and 30-day payables funds its own customers. This is why fast-growing but profitable companies still run out of money, and why negative working capital models (subscriptions, supermarkets) are so prized: customers fund the business.
What candidates get wrong
- Including cash and debt in the working capital calculation. Deal practitioners use *operating* working capital for exactly this reason.
- Getting the cash-flow sign backwards. Increase in working capital = cash outflow.
- Not knowing what a working capital peg is — the normalised level of working capital a buyer expects to be delivered at closing, with the price adjusted up or down against it.
Working Capital: frequently asked questions
Why does an increase in working capital reduce cash flow?
Because it represents cash tied up in the operating cycle. A rise in receivables means revenue was recognised but not collected; a rise in inventory means cash was spent on stock not yet sold. Both reduce cash even though neither reduces profit.
Can working capital be negative, and is that bad?
It can be, and it is often excellent. Businesses that collect from customers before paying suppliers — supermarkets, subscription software, airlines selling tickets in advance — run structurally negative working capital, meaning growth generates cash rather than consuming it.
Where Working Capital comes up
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