To quote this website: https://www.oldschoolvalue.com/blog/valuation-methods/working-capital-free-cash-flow-fcf/

"The operating parts of the asset side of working capital include: Accounts receivables, Inventories, Prepaid expenses, and some uncommon current assets found in the financials. Increasing any of these requires the use of cash.

Current liabilities also include debt which is not an operating factor of the business. (Debt is strictly a financing choice for the business.) The ones that are categorized as operations on the liabilities side are: Accounts payable & accrued expenses, Deferred revenue, Income taxes payable, and some uncommon current liabilities found in the financials. Increasing any of these delays the use of cash."

What I don't understand is how something like increasing A/R would require the use of cash (unless debt was actually bought with cash). For example, if A/R was debited, that means Service Revenue is credited, and thus there is no change to the Cash account, so how is cash being used? I understand that the receival of cash is delayed, but the cash drain does not make sense. Also, when it says "debt is not an operating factor of the business", why is A/P included as an operating liability if it is technically debt? I thought we were supposed to exclude any non-operating liabilities from this calculation of working capital?


I'll start with the formulas (yes, with an S) of working capital:

  • The traditional is simply Current assets minus Current liabilities, engulfing short term debt, current portion of long term debt and cash. This one is good to check if the company is in a decent position to meet its obligations in the next period.
  • Cash free, debt free working capital, used more from a valuation and M&A transaction standpoint, is basically the same calculation but net of interest bearing debt and cash (add debt, remove cash from traditional calculation). Its purpose is to establish how much money is needed to keep the operations flowing smoothly. It will have to be financed by either debt or equity (more on that later).

I see two questions in your post, cash use of A/R and the distinction between debt and a liability.

In your example, you refer to a service business deriving revenues from rendered services. If you render a service to a customer during a given period, you will inevitably incur costs (salaries, various office supplies) that we will assume for the sake of demonstration are cash settled the same day, will drag your money. You could see A/R as the sum of sold salaries, inventories, material and also profit. Therefore, one looking for short term financing is literally asking the bank to support its profits (see below).

Liabilities are, as you're already aware, amounts owed through contractual agreement to a third party that will ultimately require a cash outlay. Those contracts can take many forms, but we'll focus on operational and financial.

A/P are an operational liability, arising from accrued salaries, unpaid suppliers (more on this later) and so on. They usually don't bear interest, and therefore are financing yourself for free on your suppliers (you know, their A/R you had to finance earlier). Debt, on the other hand is a financial liability, part of the financial structure decided by the management to run the business. To make the company viable, enough capital has to be invested to support the working capital, various machinery and equipment, acquisitions and the list goes on. Depending on their appetite for risk, more or less debt will be used to finance the venture, the balance being equity.

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