How Does Working Capital Affect Free Cash Flow?

Updated: Sep 7, 2021

The general formula for free cash flow to firm is:

Earnings Before Interest and Taxes * ( 1- Tax Rate)

+ Depreciation & Amortization

- Increase In Net Non-Cash Working Capital (NCWC)

- Capital Expenditures


Why do we deduct the increase in net working capital from free cash flow?


First, let's remind ourselves that net working capital is the difference between a company's current assets and current liabilities and that the non-cash variation of this value merely excludes a companies cash balance from the equation. NCWC = Current Assets (excluding cash) - Current Liabilities. This means that if current assets are greater than current liabilities the company has a positive net working capital balance.


An example of some current assets are:

Cash

Accounts Receivable

Inventory


An example of some current liabilities:

Accounts Payable


Examples

1)

An increase in accounts receivable results in an increase in networking capital. According to our free cash flow formula, this increase in net working capital should result in lower free cash flow. Let's run through a typical sale transaction to see why this is the case.

The sale is made on trade credit and recorded before the cash is received. In order to record this transaction, the accounts receivable balance is debited (increased) $100 on the balance sheet. An extra $100 dollars of sales is added to the income statement even though the cash has not been collected yet. The result is the EBIT value includes $100 of sales (which we use as our starting point for our calculation) which have not been collected. In order to adjust for this, we reduce FCF by the amount of the increase in accounts receivable. Put simply, the accounts receivable balance represents sales that we have included in our income statement but not yet actually collected.


If the company collects the cash from the customer some time down the road the accounts receivable balance will decrease even though the sale it pertains to has already been put through the P&L.


2)

An increase in the payables balance works much the same way. The increase in the payables balance reduces net working capital and according to the equation, should increase free cash flow. Let's run through a typical transaction to see why this is the case.

The company has incurred an expense and recognized it on the income statement which reduces EBIT. Instead of paying cash, they used trade credit. The increase in the accounts payable balance reduces net working capital. By increasing the payables balance the company was able to record an expense without actually paying any cash for it. This shows up on the balance sheet as a decrease in the net working capital balance.


If the company pays the cash to the supplier some time down the road the accounts payable balance will decrease even though the expense it pertains to has already been put through the P&L.


The examples described above cover only 2 of the many working capital accounts but the same principles apply to any transaction involving a change in working capital. That means instead of going through each working capital account separately, we can take all of the changes into account simultaneously by simply using the net change in non-cash working capital.


See Also: https://www.theenterprisingcanadian.com/post/free-cash-flow-a-must-know