Working Capital

Recall from the balance sheet that current assets represent assets that can be converted into cash within one year, while current liabilities represent obligations due within one year. Working capital, calculated as current assets less current liabilities (Exhibit 7.6), is an important measure of a company’s ability to cover day-to-day operating activities.

Exhibit 7.6. Working Capital is an Important Measure of a Company’s Ability to Cover Day-to-Day Operating Activities

[View full size image]

In addition to adding back depreciation expense in order to reconcile Generally Accepted Accounting Principles (GAAP) net income to cash from operations, we must also incorporate changes in working capital:

• The cash flow statement is a reconciliation of what happens to cash during a reported period.

• If working capital balances changed from one year to the next, there is a corresponding cash impact that must be represented on the cash flow statement.

Companies often break out changes in working capital into its individual components on their cash flow statement (Exhibit 7.7):

• Changes in accounts receivable

• Changes in inventories

• Changes in all other current assets (except cash)

• Changes in accounts payable

• Changes in other current operating liabilities (nondebt)

Exhibit 7.7. Working Capital is an Important Measure of a Company’s Ability to Cover Day-to-Day Operating Activities

Source: Used with permission of Wal-Mart Inc.

[View full size image]

Notice that while working capital definition includes cash, changes in working capital on the cash flow statement do not take cash into account; this is because the ultimate purpose of the cash flow statement is to determine the cash impact of the company’s operative, investing, and financing activities.

Notice that working capital does not include short-term debt even though it is a current liability; this is because changes in debt are recorded in the financing section of the cash flow statement.