What Causes Change in Working Capital: Everything You Need to Know

Introduction

Working capital, often referred to as the lifeblood of a business, represents the funds available for day-to-day operations. It encompasses current assets such as cash, inventory, and accounts receivable, minus current liabilities like accounts payable and short-term debt. Changes in working capital reflect the fluctuations in a company’s short-term assets and liabilities over a specific period.

Understanding the factors driving changes in working capital is essential for evaluating a company’s financial health and operational efficiency. From shifts in market demand to variations in supplier terms, various internal and external factors can influence working capital dynamics.

This article explores the key drivers behind changes in working capital and their implications for businesses striving to maintain financial stability and sustainable growth.

What is Change in Net Working Capital?

The change in net working capital refers to the difference between the net working capital of a company in two consecutive periods. It is calculated by subtracting the net working capital of the earlier period from that of the later period. 

Change in net working capital is a crucial metric as it reflects how efficiently a company manages its short-term assets and liabilities over time.

What Causes Changes in Net Working Capital?

Changes in net working capital can occur due to various factors within a business. Some common causes include:

1. Long-Term Loans: Obtaining a long-term loan to replace a current liability decreases current liabilities without changing current assets, resulting in increased working capital.
2. Capital Expenditures: Using cash for purchases like vehicles or building expansions reduces current assets without affecting liabilities, causing a decrease in working capital.
3. Sales of Merchandise: Selling inventory at a profit increases current assets, positively impacting working capital.
4. Borrowing and Repayment: Borrowing money without affecting current assets or liabilities does not change working capital, as both cash and loans payable increase.
5. Accounts Receivable Collection: Collecting accounts receivable increases cash but decreases accounts receivable, resulting in no change in working capital.

How to Calculate Change in Net Working Capital (NWC)

To calculate the change in net working capital (NWC), you subtract the NWC balance of the prior period from the NWC balance of the current period. The formula is simple:

But before calculating the change in NWC, you first need to determine your NWC. Here’s how to find it:

• Add Up All Current Assets: Total all of the company’s current assets, which include cash, accounts receivable, and inventory.
• Subtract Current Liabilities: From the total current assets, subtract the company’s current liabilities, such as accounts payable.

The formula for calculating net working capital is straightforward:

Net Working Capital = Current Assets – Current Liabilities

Alternatively, you can use a more specific formula that excludes cash and debt:

Net Working Capital = Accounts Receivable + Inventory – Accounts Payable

By following these steps, you can accurately calculate your net working capital and then determine any changes over time.

Exploring Net Working Capital: Real-Life Examples and Implications

Examples of changes in net working capital include scenarios where a company’s operating assets grow faster than its operating liabilities, leading to a positive change in net working capital. This means the company retains more cash in its operations each year.

For instance, suppose a retail company experiences an increase in sales, resulting in higher accounts receivable (A/R) due to credit sales. At the same time, the company effectively manages its inventory levels and negotiates favorable payment terms with suppliers, resulting in slower growth in accounts payable (A/P). As a result, the company’s net working capital increases, reflecting improved liquidity and financial strength.

Conversely, negative working capital occurs if a company’s operating liabilities outpace the growth in operating assets. This situation is often temporary and arises when a business makes significant investments, such as purchasing additional stock, new products, or equipment.

For example, consider a manufacturing company facing challenges in collecting receivables from customers, leading to a significant increase in A/R. Meanwhile, the company experiences rapid growth in production, requiring increased inventory levels and faster payments to suppliers, causing a surge in A/P. In this scenario, the company’s net working capital decreases, signaling potential cash flow constraints and liquidity challenges.

Ultimately, changes in net working capital impact a company’s cash flow and financial health, highlighting the importance of monitoring these fluctuations for effective financial management.

Tips to Increase Working Capital

Improving working capital is crucial for ensuring that you have sufficient assets to meet your liabilities. Here’s how

1. Streamline your inventory managementOne of the main culprits of tied-up capital is excessive inventory. Take a close look at your inventory levels and identify any slow-moving or obsolete items. By optimizing your inventory management, you can free up cash that can be used for other purposes, such as paying off debts or investing in new projects.

2. Negotiate favorable payment terms with suppliersBuilding strong relationships with your suppliers can be beneficial in more ways than one. By negotiating longer payment terms, you can extend the time it takes to pay your bills, giving you more flexibility with your cash flow. This can help improve your working capital position and provide you with additional funds to reinvest in your business.

3. Improve your cash conversion cycleThe cash conversion cycle gauges how long a company requires to transform its investments in inventory and other assets into cash generated from sales.By reducing this cycle, you can accelerate the inflow of cash into your business, which in turn increases your working capital. This can be achieved by shortening the time it takes to collect payments from customers or by optimizing your production and delivery processes.

4. Implement effective credit control measuresLate payments from customers can have a significant impact on your working capital. To avoid this, establish clear credit policies and procedures, conduct thorough credit checks on new customers, and follow up promptly on any overdue invoices. By ensuring timely payments, you can maintain a healthy cash flow and improve your working capital position.

5. Automate invoicing to enhance efficiencyTo optimize working capital, prioritize improving invoicing processes. Establish transparent payment terms upfront and promptly dispatch invoices. Offer diverse payment options and automate reminders to prompt timely payments, minimizing delays. In case of overdue payments, politely follow up and maintain strong customer relations to foster trust and encourage prompt settlements. Regularly review and update invoicing procedures, incorporating industry best practices and technological advancements for sustained efficiency.Furthermore, streamline operations, reduce errors, and cut down on operating expenses by automating the invoicing process workflow. Automate invoice delivery across multiple channels, including emails, customer portals, accounting systems, post, and fax, ensuring efficient communication and enhancing overall workflow efficiency. 

Scrutinize the workflow to identify processes suitable for automation, thereby enhancing overall efficiency and contributing to improved working capital management.

FAQs

1). What does the change in working capital on the balance sheet represent?

It represents the difference between current assets and current liabilities. It shows how efficiently a company manages its short-term resources to meet its operational needs. Positive change indicates improved liquidity, while negative change may signal financial difficulties.

2). What does changes in working capital in the income statement represent?

It reflects the fluctuations in a company’s short-term assets and liabilities. It shows how efficiently a company manages its current resources, such as cash, inventory, and accounts payable. Positive changes indicate improved liquidity, while negative changes may suggest financial strain.

3). Can working capital be zero?

Yes, working capital can be zero if a company’s current assets match its current liabilities. While this doesn’t always indicate financial health, businesses should manage their working capital carefully to have adequate liquidity and meet short-term obligations.

4). How to find change in NWC on cash flow statement?

To find the change in Net Working Capital (NWC) on a cash flow statement, subtract the NWC of the previous period from the NWC of the current period. This calculation helps assess a company’s short-term liquidity and operational efficiency.