What Is Working Capital?
Working capital measures a company's short-term financial position: Working Capital = Current Assets - Current Liabilities. Current assets include cash, accounts receivable, and inventory, while current liabilities include accounts payable and other obligations due within a year.
In financial modeling, analysts usually focus on net working capital excluding cash and debt, which captures the operating items: receivables and inventory minus payables and accrued expenses. This version isolates how much cash the operating cycle itself ties up.
How Changes in Working Capital Affect Cash
When working capital increases, cash decreases, and vice versa. If receivables or inventory grow, the company has delivered goods or bought stock without yet collecting cash, so cash is tied up; if payables grow, the company is holding onto cash longer by paying suppliers later.
This is why a fast-growing company can be profitable on paper yet constantly short of cash: every new dollar of sales requires funding more receivables and inventory before customers pay.
Example
A distributor holds $500,000 of receivables and $300,000 of inventory against $400,000 of payables, so net working capital is $500,000 + $300,000 - $400,000 = $400,000. If sales double and each component scales proportionally, working capital rises to $800,000, meaning the business must find $400,000 of extra cash just to fund its own growth.
Why It Matters
Working capital efficiency separates businesses that generate cash as they grow from those that consume it. Companies with negative working capital, like many subscription businesses that collect from customers before paying suppliers, effectively get free financing from growth.
The change in net working capital is a required line in every DCF and LBO model, and interviewers frequently test whether candidates know that an increase in working capital is a use of cash.
