Working capital and cash flow are two of the most fundamental concepts of financial analysis. Working capital is associated with the balance sheet on a company's financial statement whereas cash flow is associated with the cash flow statement of a company's financial statement.

As the different sections of a financial statement impact one another, changes in working capital affect the cash flow of a company. To find out how, it's important to understand the components themselves.

Working Capital

Working capital represents the difference between a firm’s current assets and current liabilities. Working capital, also called net working capital, is the amount of money a company has available to pay its short-term expenses.

Positive working capital is when a company has more current assets than current liabilities, meaning that the company can fully cover its short-term liabilities as they come due in the next 12 months. Positive working capital is a sign of financial strength. However, having an excessive amount of working capital for a long time might indicate that the company is not managing its assets effectively.

Negative working capital is when the current liabilities exceed the current assets, and the working capital is negative. Working capital could be temporarily negative if the company had a large cash outlay as a result of a large purchase of products and services from its vendors.

However, if the working capital is negative for an extended period of time, it may be a cause for concern for certain types of companies, indicating that they are struggling to make ends meet and have to rely on borrowing or stock issuances to finance their working capital.

Cash Flow

Cash Flow is the net amount of cash and cash-equivalents being transferred in and out of a company. 

Positive cash flow indicates that a company's liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses, and provide a buffer against future financial challenges.

Negative cash flow can occur if operating activities don't generate enough cash to stay liquid. This can happen if profits are tied up in accounts receivable and inventory, or if a company spends too much on capital expenditures.

Understanding the cash flow statement, which reports operating cash flow, investing cash flow, and financing cash flow is essential for assessing a company’s liquidity, flexibility, and overall financial performance.

How Working Capital Impacts Cash Flow

Changes in working capital are reflected in a firm’s cash flow statement. Here are some examples of how cash and working capital can be impacted.

If a transaction increases current assets and current liabilities by the same amount, there would be no change in working capital. For example, if a company received cash from short-term debt to be paid in 60 days, there would be an increase in the cash flow statement. However, there would be no increase in working capital, because the proceeds from the loan would be a current asset or cash, and the note payable would be a current liability since it's a short-term loan. 

  • If a company purchased a fixed asset such as a building, the company's cash flow would decrease. The company's working capital would also decrease since the cash portion of current assets would be reduced, but current liabilities would remain unchanged because it would be long-term debt. 
  • Conversely, selling a fixed asset would boost cash flow and working capital.
  • If a company purchased inventory with cash, there would be no change in working capital because inventory and cash are both current assets. However, cash flow would be reduced by inventory purchases. 

Below is Exxon Mobil's (XOM) balance sheet from the company's 10K statement for 2017. We can see current assets of $47.1 billion (blue) and current liabilities of $57.7 billion (red).

  • Highlighted in green is cash of $3.1 billion and inventories of $4.1 billion.
  • If Exxon decided to spend an additional $3 billion to purchase inventory, cash would be reduced by $3 billion, but materials and supplies would be increased by $3 billion to $7.1 billion.
  • There would be no change in working capital, but operating cash flow would decrease by $3 billion.

Imagine if Exxon borrowed an additional $20 billion in long-term debt, boosting the current amount of $24.4 billion (listed below the red shaded area) to $44.4 billion. Cash flow would increase by $20 billion. Working capital would also increase by $20 billion. The amount would be added to current assets without any debt added to current liabilities; since current liabilities are short term, one year or less, and the $20 billion in debt is long term.

The Bottom Line

A company’s working capital is a core part of funding its daily operations. However, it's important to analyze both the working capital and the cash flow of a company to determine whether the financial activity is a short-term or long-term event.

A boost in cash flow and working capital might not be good if the company is taking on long-term debt that doesn't generate enough cash flow to pay it off. Conversely, a large decrease in cash flow and working capital might not be so bad if the company is using the proceeds to invest in long-term fixed assets that will generate earnings in the years to come.