Working capital

Trying to understand accounting (better). I got pretty confused about working capital in combination with cash flow. Most sites seem to have the minus/plus signs wrong even in the book I am reading. So here goes my stab at it.

First off earnings, Net Income, Accounts payable etc in this article all actually refer to increases/decreases not absolute values.

Just for the record if I say ‘increase in X’ it means that if I first had 5 and later 10, the increase is a positive number 5. If I say ‘decrease in X’ then if I first had 10 and then 5 the decrease is a positive number 5.

Short story

Net Income is the money we received during this period and you could say we could add this to what we have in cash (i.e. real tangible money (well, OK, money in our bank account, counts too)).  However money we have yet to receive from our customers is also in this number since it are earnings but we haven’t received the money yet. The reverse for bills we have to pay, although not included in our Net Income (since theoretically we don’t have it anymore) we still have it in cash since we didn’t pay those bills yet.

Also if we increase our inventory we would have payed that with cash. This is not visible in the income statement since it doesn’t matter for our net income if we used that money to buy more inventory. But obviously we would have less cash now. So an increase in inventory will decrease our cash.

So instead of just adding the Net Income and therefore increasing what we have in cash we have to subtract the increase in accounts receivable, subtract increase in inventory, while adding the increase in accounts payable.

Long Story

Working Capital (Capital tied up in the company) = Current Assets (e.g. Inventory, Accounts Receivable) – Current liabilities (e.g. Accounts Payable)
Inventory (using LIFO or FIFO (goods in inventory are valuated against the old price, reasoning is that the new coming in are already sold so only the old goods are in the inventory, vice versa for LIFO).
On the cash flow statement we subtract changes in working capital, from the Net Income, since the more we have in working capital the less we can see in cash from what we earned.

Net income includes increase in Accounts Receivable, Minus increase in accounts payable. For Net Income it doesn’t matter we bought more inventory also though Accounts Receivable for instance increased this is not money we actually have in cash. So for the cash flow statement we have to subtract the increase in accounts receivable and subtract increase in inventory to understand how much our cash increased while adding the increase in accounts payable since an increase in Accounts Payable means we didn’t pay those bills and we still have it in cash.

Income statement (simplified)
Revenue
-COGS (Cost of goods sold, or cost of revenue)
+ Increase in Accounts Receivable
– Increase in Accounts Payable
Other stuff  (for instance amortization and depreciation (subtract those too))
+—————
Net Income

Cash flow (simplified)
Net Income What we have in cash would increase by the Net Income, but
– Increase in accounts receivable because we don’t have this in cash yet
+ Increase in accounts payable because we have it in cash because we didn’t pay those bills yet.

–  Increase in inventory since we used some of our cash for new inventory

Other stuff (for instance amortization and depreciation (add those too))
+—————
Increase in cash
Cash previous period
+—————
Total in cash now

 

Or using increase in working capital

Increase in Cash = Net Income – Increase in working capital + Other stuff

 

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