Why Increases in Net Working Capital Reduce Free Cash Flow
Summary
The document explains why an increase in net working capital is subtracted when estimating free cash flow. Working capital represents resources needed to run the business. When operating current assets rise relative to operating current liabilities, more cash is committed to operations and is unavailable for other uses during that period. A decrease can release resources and make cash available for investment or distribution.
The answers clarify that, in an operating-business context, net working capital typically excludes cash and uses operating assets and liabilities, excluding financing items such as debt. This addresses the concern that an increase in working capital might simply mean the company has more cash: cash is generally excluded from this measure. The explanation is conceptual and does not develop exceptions or a detailed company-specific calculation. Definitions can also vary by analytical purpose, so the exact items included should be made explicit when applying the formula.
Key ideas
- An increase in operating net working capital ties up cash in the business and reduces free cash flow.
- A decrease in net working capital can release cash for other uses.
- Operating net working capital commonly excludes cash and financing liabilities such as debt.
- Net working capital definitions may vary, so the included balance-sheet items matter.
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# Why subtract increase in net working capital to get Free Cash Flows? # Why subtract increase in net working capital to get Free Cash Flows? Here's the formula for free cash flows I'll be referring to: FCF = EBIT*(1-Tax Rate) + Depreciation and Amortization – Capital Expenditures – Increases in Net Working Capital (NWC) If you have an increase in net working capital, you have more current assets than liabilities than you did in the previous period. So if you now have an increase in net working capital of, say, 10, why would you subtract this to get your free cash flow? Since current assets include cash, wouldn't you be subtracting an increase in cash (in some cases) from your free cash flow? ## Answer by RHO (score 5) https://quant.stackexchange.com/a/37484 An increase in working capital figure (current assets are greater than current liabilities) requires additional cash to be tied up in operations because an increase in current assets is a net outflow. In contrast, a decrease in working capital position means the firm has more cash available that can be used for other projects since an increase in current liabilities is a net inflow. I hope this answers your question. ## Answer by Nathan (score 4) https://quant.stackexchange.com/a/64263 For acquisitions, NWC is current operating assets (excluding cash because it is a non operating asset) less current operating liabilities (excluding debt and debt like liabilities - which are non operating liabilities). In other words it's calculated on a cash free, debt free basis (common practice at Big 4 accounting firms). This calculation will give you the amount of cash that is required to operate the core business at a given time. Taking it one step further, if you normalize that amount over a historical period, it will tell you on avg. how much capital is required to operate the core business. Looking at it this way, I think it's a lot easier to see why NWC is subtracted in the equation to reach FCF. As noted above FCF is FREE cash flow, so that money is free to be used in any way the business operators see fit (dividends, stock buybacks, investing in projects, etc.) - Thanks!
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