Change in Working Capital Formula
Short term working capital is the difference between current assets and current liabilities used in the day to day trading operations of a business. Consequently a change in working capital is any net change in current assets and current liabilities over an accounting period.
In most businesses working capital amounts to inventory plus accounts receivable less accounts payable. This 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.
As can be seen any net movement in inventory, accounts receivable or accounts payable over an accounting period, results in a corresponding net movement 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 which is utilised to carry out its normal day to day trading operations.
Consequently the change in working capital equation can be stated as follows:
Change in Working Capital Calculation
It is important to realize that as inventory, accounts receivable, and accounts payable are found on the balance sheet of the business, the net movement in working capital can be found by taking the difference between the closing and opening balance sheets for the period.
Example
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 | 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 |
As can be seen the change in working capital formula gives:
| Inventory | + | AR | – | AP | = | 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 | 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 |
In contrast the change in working capital formula now 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 movement 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. As shown above 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. Accordingly 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.
It is important to realize that a 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. Subsequently without adequate working capital financing in place, this increase in net working capital can lead to the business overtrading and running out of cash.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.