What Changes in Working Capital Impacts Cash Flow?

 | 
July 29, 2022
UPDATED: 
July 29, 2022
What Changes in Working Capital Impacts Cash Flow?

Talking about the business working capital, you calculate it by subtracting current liabilities from your existing assets. The current liabilities include short-term loans, income tax payable, accounts payable, etc. Meanwhile, your business's current assets include accounts receivable, cash in hand, liquidated investments, etc. You calculate working capital for your business during a financial analysis. 

When you perform the financial analysis, you consider two core concepts - Working capital and Cash flow. Working capital is shown on your company's balance sheet. Meanwhile, cash flow is shown in the cash flow statement in the books of business or a company. One needs to maintain the financial statements so that everything is tallied. However, when there is a change in the working capital, it affects the cash flow too. 

What is working capital?

Calculating working capital is easy. You get the net working capital by subtracting current liabilities from your business's assets. 

Positive working capital: In this situation, your company's current assets are more than your current liabilities. If you have short-term expenses, you can easily cover them over the next year. Furthermore, positive working capital indicates the financial strength of the company. Meanwhile, if your company has not used the working capital for a long time, it shows that your assets are not appropriately managed. 

Negative working capital: In this situation, your company's current liabilities are more than the number of current assets. For some reason, your working capital may show a temporary negative balance. For example, when you incur a significant expenditure, etc. Make sure you don't have a prolonged negative working capital balance. It might make you struggle for funds. 

What is cash flow?

The amount of cash transactions done in and out of the company is called cash flow. 

Positive cash flow: When you have this situation, your company's liquid assets are on the increasing trend. Furthermore, you can meet expenditures such as paying to shareholders, setting the debts, reinvesting in your business, and much more. 

Negative cash flow: In this situation, your company experiences a decline in the cash flow. In addition to this, your liquidity impacts you in the long run. Furthermore, you might eventually run out of cash if you spend too much on capital expenditures. Secondly, it affects the overall financial performance of a business. 

How do changes in working capital impact cash flow?

May it be the receipt of revenues or paying the expenses, everything is done in cash. Meanwhile, cash receipts and payments form a part of the profit and loss statement of the company. It is different from the revenues and expenditures incurred. 

Accounts receivable, account payable, and inventory changes affect the net cash flows. Meanwhile, you as a company cannot make receipts and payments using cash. In addition, there needs to be a change in the calculation of operational cash flows. 

Talking about the debtors, creditors, and your inventory, they do impact your financial operations. Furthermore, such modifications need to keep a check over the routine changes. However, if there is a mismatch in taking care of the payments and expenditure, you must ensure the correct calculation.  

Key points impacting cash flow & working capital

  • If there is a break-even of current assets and liabilities, working capital is not changed.
  • If your business makes a significant investment, e.g., a property, the cash flow decreases. Meanwhile, the working capital decreases because the current asset's cash portion is reduced. 
  • Your business's current liabilities are not impacted when you make a significant investment. It is because the same is seen as long-term debt.
  • If your business sells a fixed asset, in this case, the cash flow and working capital both increase. 
  • If your business purchases inventory by cash, there is no impact on the working capital. It is because both are treated as current assets. However, cash flow is impacted and would be reduced. 
  • If there is a change in the accounts receivable, it may increase due to non-payment of customer bills. During this situation, the cash inflow is impacted. 
  • If an unsold inventory exists in the business, it doesn't include cash payment in the expenditure. The cash flow is impacted and reduced. 
  • An increase in the accounts payable happens when the business delays paying for the sales or material. Cash payments and inflow are impacted. 

Wrapping it up 

There you have it. You know about the working capital and cash flow. Secondly, how they are impacted depends on what kind of financial activity is undertaken by the business. One should always analyze the situation, thereby keeping a balance of cash flow and net working capital.

Managing money with cash flow and working capital is crucial for the business. Both of them work in tandem, and you must make sure to strengthen the financial status of a company. 

Author

  • Chuck is Score LA’s Executive Director of Events and Marketing. He aims to help business owners and would-be entrepreneurs in Los Angeles improve their business practices.

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