Change in Working Capital

Change in Working Capital Calculation

Short term working capital is the difference between current assets and current liabilities used in the day to day trading operations of a business.

In most businesses this amounts to inventory plus accounts receivable less accounts payable, which represents the funding needed to buy inventory and provide credit to customers, reduced by the amount of credit obtained from suppliers.

The working capital calculation is given by the following formula.

Working capital = Inventory + Accounts receivable – Accounts payable

Any net change in inventory, accounts receivable or accounts payable over an accounting period, results in a corresponding net change in working capital. As the other side of the entry has to be represented by cash, the change in working capital also represents a cash flow in or out of the business.

The change in working capital equation can be stated as follows:

Change in working capital = Change in (Inventory + Accounts receivable – Accounts payable)

Change in Working Capital Example

As inventory, accounts receivable, and accounts payable are found on the balance sheet of the business, the change in working capital can be found by taking the difference between the closing and opening balance sheets for the period.

For example, if a business buys 3,000 of inventory from a supplier, and the accounts payable increases by 3,000 as the supplier account has not been paid, then extracts from the balance sheet would show the following:

Balance Sheet Extract – Change in working capital
Balance sheet Begin End Change
Cash 0 0 0
Inventory 0 3,000 3,000
Accounts receivable 0 0 0
Accounts payable 0 -3,000 -3,000
Working capital 0 0 0

The change in working capital formula gives:

 Inventory + A/cs receivable – A/cs payable = Working capital 3,000 + 0 – 3,000 = 0

The increase in the inventory has been matched by a corresponding increase in accounts payable so the net change in working capital is zero, and the corresponding cash flow from the business is zero.

If on the other hand the supplier had been paid and there was no corresponding increase in accounts payable, the extracts from the balance sheet would show the following situation:

Balance Sheet Extract – Change in working capital
Balance sheet Begin End Change
Cash 0 -3,000 -3,000
Inventory 0 3,000 3,000
Accounts receivable 0 0 0
Accounts payable 0 0 0
Working capital 0 3,000 3,000

The change in working capital formula gives:

 Inventory + A/cs receivable – A/cs payable = Working capital 3,000 + 0 – 0 = 3,000

The working capital has increased by the value of the inventory 3,000, but there has been no corresponding increase in accounts payable, so the net change in working capital is 3,000 reflected by the cash flow out of the business (-3,000) to pay the supplier.

Change in Working Capital Cash Flow Statement

Operating net working capital can be viewed as the amount of cash tied up in the net funding of inventory, accounts receivable, and accounts payable. A change in inventory, accounts receivable, and accounts payable results in a change in working capital and a cash flow in or out of the business. This cash flow is shown as part of the cash flow statement under the heading operating cash flow.

It is important for a business to have a simple system to monitor working capital and changes in working capitol, by for example, calculating working capital as a percentage of sales.

Failure to monitor changes in working capital can lead a business to run out of cash. For example, a growing business might be profitable but as it expands, the growth often leads to a substantial increase in inventory and accounts receivable without a corresponding increase in accounts payable. Without adequate working capital financing in place, this increase in net working capital can lead to the business over trading and running out of cash.

Change in Working Capital November 6th, 2016

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