Understanding the Change in Working Capital: What Every Small Business Needs to Know

Your working capital at any given time is a reliable measurement of your company’s liquidity and financial health. And when you manage your working capital well, you can strike a healthy balance between growth and profitability.

Working capital fluctuates, and understanding these changes is essential for better financial management. This guide covers what working capital change is and how to calculate and interpret it.

Read on and discover all you need to know about this topic for your small business.

What Is Working Capital?

Working capital is the difference between a company’s current assets and current liabilities. Put another way, it shows how much capital is available as assets vs what is owed in liabilities. Therefore,  it answers the question of whether or not the company could pay off its current liabilities with its current assets.

Examples of current assets are cash on hand or cash equivalents, and any accounts receivable, marketable securities, and stock inventory that can be converted to cash within one year.

Examples of current liabilities are accounts payable, dividends payable, accrued expenses, and short-term debt due within one year.

Working capital represents operating liquidity, and is also commonly referred to as net working capital (NWC).

Is Working Capital the Same as Free Cash Flow?

In a nutshell, cash flow is the money flowing through a company. Free cash flow is the money a company produces through its operations after operating expenses. This is not the same as working capital, which is the monetary difference between current assets and current liabilities.

These measurements all tell an important financial story about the company’s financial health including its productivity, profitability, and liquidity. However, the company’s cash flow, free cash flow, and working capital tell different sides of that story and only working capital factors in current liabilities.

Cash Flow Statement vs Balance Sheet: Why the Difference Matters

The cash flow statement shows a business’s day-to-day cash activities. Therefore, it shows how much cash a company has on hand during a specific period.

The balance sheet, on the other hand, shows the working capital available to the business by listing the business’s current assets and liabilities. Therefore, it gives a more comprehensive picture of a business’s financial health.

Although both are important, your working capital is what will more accurately tell you whether your business is financially liquid or under financial stress.

What Is Change in Working Capital?

So, if net working capital is the difference between a company’s assets and liabilities at any given time, what does “change in working capital” mean? Change in Net Working Capital (NWC) measures the net change in a business’s operating assets and liabilities within a specific timeframe.

A change in net working capital is the difference between a company’s available funds and outstanding payments in a specific accounting period, compared to previous accounting periods.

Why Is Change in Net Working Capital Important?

By measuring working capital and observing the change in working capital, a company can measure its liquidity and operational efficiency. Changes in working capital can indicate potential cash flow management issues. This offers the opportunity to take corrective action and restore a healthy cash flow.

This is especially important in manufacturing businesses, where poorly managed working capital can impact the acquisition of raw materials and the entire production process. Read our guide to working capital for manufacturing businesses to learn more.

Impact of Changes in Working Capital on Business

A change in your working capital has a direct effect on a business; the more dramatic the change, the bigger the impact on short-term financial health.

Extra working capital allows businesses to do much more than settle their immediate debts. It offers them the opportunity to make investments that will ensure future growth. Unfortunately, a lack of working capital can mean that short-term debts will not be settled.

What Causes Changes in Working Capital?

A change in the working capital can have a major impact on a company, but what causes the change? Multiple factors affect the increase or decrease of net working capital and thus change the ratio of current assets to current liabilities.

Accounts Receivable

A business’s accounts receivable is the money owed to a business for goods or services its customers have not yet paid for. It represents money that is due to come in shortly and is therefore listed on the balance sheet as a current asset.

Accounts Payable

A business’s accounts payable is the money owed by the business for goods or services it has not yet paid for. It represents money that is due to flow out shortly and is therefore listed on the balance sheet as a current liability.

Inventory Management

Inventory management describes the process of ordering and using raw materials and components to produce and sell finished products. The storage of such materials, the work-in-progress, and the warehousing of the products for sale also fall under the umbrella term of inventory management.

Business Purchases

Businesses purchase different types of goods or services, which may be directly or indirectly related to production.

For example, a business may use its working capital to purchase raw materials or machine parts to produce items. It may also purchase specialized software to keep the business running smoothly or marketing services to promote business growth.

Cash Investments

Cash investments are low-risk investment options that allow businesses to capitalize on any surplus cash. Allocating extra funds to savings accounts is an obvious example but by no means the only example of making a cash investment.

Marketable Securities

Marketable securities are short-term, liquid financial instruments that can be converted into cash very quickly when necessary. They offer an alternative to simple cash investments. Marketable securities are current assets that can, like any other current assets, affect a change in net working capital.

Loans

Businesses take out business loans to have access to extra funding for a variety of reasons. These loans can be used to purchase more inventory, cover short-term debts, or even keep the business afloat when working capital is too low for day-to-day operations.

Business Growth

Businesses can have different goals but the most common goal across industries and sectors is that of business growth. This is achieved in several ways. Signs of growth include an increased customer base, increased revenue, and eventual expansion to attain a larger share of the market.

How to Calculate Working Capital Change

It isn’t difficult to calculate the changes in working capital for your business.

First, you’ll need to decide which period you want to calculate your working capital change for. This may be a month, quarter, or year. Next, you’ll have to check what your assets and liabilities are for the start of that period and what they currently are.

Then, all you need is this simple change in working capital formula to apply that information. And before you know it, you’ll have a snapshot of your business’s financial health.

Change in Working Capital Formula

The formula is as follows:

Change in Net Working Capital = NWC (Current Period) – NWC (Previous Period)

Or looked at in another way:

Change in Net Working Capital = NWC (End of Period/EoP) – NWC (Beginning of Period/BoP)

Let’s break that down. It’s the difference when subtracting the NWC available at the beginning of the period in question, from the NWC at the end of that period. By subtracting the previous period’s NWC from the current NWC, you will immediately see if the NWC has increased or decreased.

Examples of Change in Working Capital Calculations

Let’s look at some examples of changes in working capital calculation.

• We will assume that the NWC was $500 at the beginning of the period, and at the end of the period, it was $1000. Therefore, the Change in Net Working Capital = $1000 EoP – $500 BoP, and the difference is $500. This means that the change in working capital was a $500 increase.
• Next, we will assume that the NWC was $1000 in the previous period, but in the current period, it is $500. Therefore, the Change in Net Working Capital = $500 – $1000, and the difference is still $500, but it was a $500 decrease.
• Let’s do one more. This time, the NWC at the beginning and the end of the period was $1000. So, using the same formula, the Change in Net Working Capital = $1000 EoP -$1000 BoP. There was, in fact, no change as the NWC has remained the same.

Any small differences of $100 or more over a long period would be negligible and mean the same as if there was no change. See our FAQ section below to find out what a negligible change in working capital can mean.

How to Interpret Changes in Working Capital

The change of working capital formula and calculation will only take you so far, though. You need to interpret the changes in working capital. That means you must know the difference between positive and negative changes in working capital and what they mean for your company.

Positive Changes in Working Capital

When the net working capital is more in the current period than the previous period, it has increased. The change in working capital is said to be positive.

What does a positive NWC change tell you about your company?

It could mean that your current assets in the current period have increased more than the current liabilities in the same period. You should be able to cover your short-term debts and expenses more easily.

A positive working capital change l is not always a good thing. In our experience, when the increase in current NWC is very high, it can indicate an underutilization of resources.

Negative Changes in Working Capital

When the net working capital is less in the current period than in the previous period, it has decreased. The change in working capital is said to be negative. You may struggle to cover the short term.

What does a negative NWC change tell you about your business?

It could mean that your current liabilities in the current period have increased more than the current assets in the same period. You may struggle to meet your short-term obligations.

A negative working capital change is not always a bad thing. We have observed that it can signify growth. This is true if the decrease in current net working capital is due to purchasing a large inventory or investing in new equipment to expand the business.

Conclusion

Working capital is constantly fluctuating, altering the delicate balance between current assets and current liabilities. That said, a dramatic change in working capital from one period to the next can signify equally dramatic consequences for your company.

Understanding the change in working capital, and how to interpret it, will help you make the best of your financial situation. But there are times when you’ll need an immediate boost in working capital to take that next step toward business success.

E-Boost Partners can help. We offer small businesses access to business financing solutions and merchant services. Contact us today to learn how we can help you.