Changes in Working Capital

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Changes in Working Capital is the net change in current assets and current liabilities.

Working Capital is a measure of a company's short term liquidity or its ability to cover short term liabilities. Working capital is defined as the difference between a company's current assets and current liabilities. That is,

Working Capital = Current Assets - Current Liabilities.

Changes in Working Capital is reported in the cash flow statement since it is one of the major ways in which net income can differ from operating cash flow. Under the accruals system, companies calculate revenue and expenditure when a transaction occurs instead of when the cash actually changes hands.

For example: If the company buys goods from its supplier, it would record it as an expense even before it pays for the goods in cash. The transaction would result in an increase in accounts payable and would be reported in the income statement as an expense. However, while an increase in accounts payable does not affect the net income, it would affect the companies cash flow -- all else being equal, an increase in accounts payable would result in a higher cash flow than net income. As a result, the company needs to reconcile this difference in the cash flow statement.

Similar changes in current assets, such as accounts receivable or inventory causes the cash flow to differ from net income. For example: An increase in accounts receivables means that the company is collecting less cash than its revenue.

The cumulative effect of all current asset and all current liabilities is captured in the changes in working capital item on the cash flow statement. All else being equal, a positive change in working capital would lead to a lower cash flow than net income for a company.

Example

Company XYZ's Working Capital (Current Assets - Current Liabilities) was $10 million. Then, XYZ closed a $2 million sale with a new client, who paid with credit. Although the company accrues the increase in revenue from the new sale, no actual cash has come in the door yet. As a result, revenue and net income increase, but cash flow would not increase until the customer paid XYZ's bill. The difference would be explained by the $2 million increase in accounts receivable, and in turn working capital.

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