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Guide to Change in Working Capital

Guide to Change in Working Capital
Mike Zaccardi
Mike ZaccardiUpdated June 24, 2022
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As a business owner, it is important to know the difference between working capital and changes in working capital. Working capital tells you the level of assets your business has available to meet its short-term obligations at a given moment in time. Change in working capital, on the other hand, measures what is happening over a given period of time with regard to the liquidity of your company.  A change in working capital is important to monitor and is often used by investors and lenders to assess the health and value of a business. Read on to learn what causes a change in working capital, how to to calculate changes in working capital, and what these changes can tell you about your business.Recommended: Understanding Different Types of Small Business Loans 

What Is Working Capital? 

Working capital is a company’s current assets minus its current liabilities. Both current assets and current liabilities are found on a company’s balance sheet. Current assets include assets a company will use in fewer than 12 months in its business operations, such as cash, accounts receivable and inventories of raw materials and finished goods. Current liabilities include accounts payable, trade credit, short-terms loans, and lines of credit. Essentially, working capital is the amount of money a company has available to pay its short-term expenses. A business has positive working capital when it currently has more current assets than current liabilities. This is a sign of financial health, since it means the company will be able to fully cover its short-term obligations as they come due over the next year. It’s possible to have too much of a good thing, however. Excessive working capital for a prolonged period of time can mean a company is not effectively managing its assets. A business has negative working capital when it currently has more liabilities than assets. This can be a temporary situation, such as when a company makes a large payment to a vendor. However, if working capital stays negative for an extended period, it can indicate that the company is struggling to make ends meet and may need to borrow money or find another way to finance their working capital.Another way to measure working capital is to look at the working capital ratio, which is current assets divided by current liabilities. Generally, a working capital ratio of less than 1.0 is an indicator of liquidity problems, while a ratio higher than 2.0 indicates good liquidity.Recommended: Guide to Working Capital Turnover 

What Is Net Working Capital? 

Net working capital is simply another name for working capital. It is a basic accounting formula companies use to determine their short-term financial health. The basic formula is:        Current Assets – Current Liabilities = Net Working Capital (or Working Capital)

What Causes Changes in Working Capital? 

There are a number of factors that can cause a change in working capital. These include:

Credit Policy

Credit policy adjustments often lead to changes in how quickly cash comes in. A tighter, stricter policy reduces accounts receivable and, in turn, frees up cash. That comes at a potential cost of lower net sales since buyers may shy away from a firm that has highly strict credit policies. Looser credit policies can have the opposite effect. As with many of these factors, there is a tradeoff to weigh. 

Accounts Payable Payment Period 

Negotiating a longer accounts payable period with your suppliers frees up cash because you have more time to pay your bills.The downside is that a supplier might increase prices in response to allowing a longer payment period. Shortening your accounts payable period can have the opposite effect, so business owners should carefully manage this policy. 

Collection Policy 

Seeking to increase cash? A tighter collection policy could help. Cash comes in sooner (and total accounts receivable shrinks) when there is a short window within which customers can hold off on paying. .A less aggressive collection policy has the opposite impact. 

Growth Rate 

Stronger growth calls for greater investment in accounts receivable and inventory, which uses up a lot of cash. This, in turn, leads to major changes in working capital from one month to the next. A slower growth rate can reduce changes in working capital. 

Inventory Planning 

Inventory decisions are a crucial factor that can lead to a change in working capital. If a company chooses to spend more on inventory to increase its fulfillment rate, it will use up more cash. Reducing inventory has the opposite effect.

Purchasing Practices 

A change in purchases practices can also lead to changes in working capital. If the purchasing department opts to buy larger quantities at one time, it can lower unit prices. However, it means a higher outlay of cash. Buying in smaller amounts can have the opposite effect. 

Hedging

Using hedging strategies to offset swings in cash flow can mitigate unexpected changes in working capital. However, there are some costs involved in these hedging transactions, which could affect cash flow.Recommended: Comparing Cash Flow and Profit: What They Are and Why They're Important 

What Impacts Can Various Changes in Working Capital Have?

Change in the working capital is the change in net working capital of the company from the one accounting period when compared with another accounting period. Changes in working capital will occur when either current assets or current liabilities  increase or decrease in value.Change in net working capital is an important indicator of a company’s financial performance and liquidity over time. By calculating the change in working capital, you can better understand your company’s capital cycle, and strategize ways to reduce it, either by collecting receivables sooner or, possibly, by delaying accounts payable.Understanding changes in cash flow is also important if you are applying for a small business loan. Lenders will often look closely at a potential borrower's working capital and change in working capital from quarter-to-quarter or year-to-year.  

Positive Impacts

If the change in working capital increases is positive, then the change in current liabilities has increased more than the current assets. This means the company’s liquidity is increasing.

Negative Impacts

If the change in working capital is negative, it means that the change in the current operating assets has increased higher than the current operating liabilities. Cash has been used, and this reduces liquidity.

Calculating Change in Working Capital 

The change in working capital formula is straightforward once you know your balance sheet. Simply take current assets and subtract current liabilities. That difference is your working capital (WC). Next, compare the firm’s working capital in the current period and subtract the working capital amount from the previous period. That difference is the change in working capital. Change in WC = Current year WC – Last year WC

Why Calculating Changes in Working Capital Is Important

As a small business owner, monitoring and understanding changes in working capital over time, whether it's quarter-over-quarter or year-over-year, can help you better understand your company’s cash flow. It’s also important if you are trying to woo an investor or get approved for a small business loan. Lenders, and investors will often look at both working capital and changes in working capital to assess a company’s financial health. Wide swings from positive to negative working capital can offer clues about a company’s business practices. A business owner can often access more attractive small business loan rates and terms when the firm has a consistent working capital policy.

The Takeaway

Working capital is a basic accounting formula (current assets minus current liabilities) business owners use to determine their short-term financial health. Changes in working capital can occur when either current assets or current liabilities increase or decrease in value. As a business owner, it’s important to not only calculate working capital but also to  monitor changes in working capital from one accounting period to another to clearly assess your company’s operational efficiency. This is especially important if you are in the market for financing. Lenders will often look at changes in working capital when assessing a company’s management style and operational efficiency.

3 Small Business Loan Tips

  1. Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
  2. Traditionally, lenders like to see a business that’s at least two years old when considering a small business loan.
  3. If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.

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The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.LCSB0322020

Frequently Asked Questions

How is change in working capital calculated?
What are some things that can affect working capital?
What changes in working capital impact cash flow?

About the Author

Mike Zaccardi

Mike Zaccardi

Mike Zaccardi, CFA, CMT, is a finance expert and writer specializing in investments, markets, personal finance, and retirement planning. He enjoys putting a narrative to complex financial data and concepts; analyzing stock market sectors, ETFs, economic data, and broad market conditions; and producing snackable content for various audiences.
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