Investopedia/Ryan C. Fuhrmann: How do changes in working capital affect a company's cash flow?

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How do changes in working capital affect a company's cash flow?

 By Ryan C. Fuhrmann, CFA | Updated May 30, 2017 — 11:50 PM EDT
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Answer:

Working capital represents the difference between a firm’s current assets and current liabilities. For well-run firms, managing working capital is simply a daily occurrence that can be handled easily. For other firms, the way the process is handled can indicate financial distress.

The impact of working capital changes are reflected in a firm’s cash flow statement. Specifically, the operating cash flow (OCF) section of the cash flow statement details changes in its shorter-term working capital needs. A positive working capital figure (current assets are greater than current liabilities) means a cash inflow for the period measured. In contrast, a negative working capital position means the firm has spent more cash out than it brought in managing its working capital, or commitments, within a year. Analyzing changes in working capital can be important for any business, but is especially important for firms with seasonal or erratic cash flow needs.

For instance, retailing giant Wal-Mart Stores Inc (WMT), like most retailers, spends a considerable amount of working capital prior to the holiday season.

Looking at Wal-Mart’s 2016 cash flow statement for the fiscal third quarter ended October 31, 2016, we can see that it spent $6.57 billion (reflected as a cash outflow) on inventory. This contrasts sharply with the other three quarters. In its first and second quarters, spending on inventory was minimal and came in at $264 million and $791 million (both cash inflows), respectively. In the fourth quarter, inventory decreased by a wide margin and the change in working capital was favorable as it went up from -$10.73 billion to -$9.24 billion.

As another example, let's look at Blockbuster, the video rental chain that went bankrupt, had a working capital situation that was much grimmer. In fiscal 2010, its change in accounts payable and accrued expenses totaled a cash outflow of nearly $250 million and it came following a reported loss of close to $600 million. At the time, cash on hand was only $190 million. With a negative working capital, the company was not able to meet its short-term obligations. Later that year, the firm filed for bankruptcy.

The Bottom Line

Most of the time, a company’s working capital is simply a core part of its daily operations. But it can indicate financial problems, especially when working capital runs in the negative for an extended period of time.
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