What Is Working Capital?
Working capital represents the operating liquidity available to a business. In its simplest form, it equals current assets minus current liabilities. For valuation purposes, bankers focus on net operating working capital, which excludes cash and current portions of debt.
Operating vs. Total Working Capital
Net operating working capital includes accounts receivable, inventory, and prepaid expenses on the asset side, and accounts payable and accrued liabilities on the liability side. Cash and short-term debt are excluded because they are captured separately in the EV bridge.
The change in NWC used in FCF calculations: Change in NWC = (Change in Operating Current Assets) − (Change in Operating Current Liabilities). An increase in NWC is a cash outflow; a decrease is a cash inflow.
Why Working Capital Changes Matter
When a company grows, it typically needs more working capital. More sales mean more AR. More production means more inventory. But higher purchasing also increases AP. The net effect determines the working capital investment needed to support growth.
A company might show strong EBITDA growth, but if working capital is increasing rapidly, actual cash flow could be much lower. Conversely, companies that manage working capital efficiently generate more cash than earnings suggest.
Working Capital as a Percentage of Revenue
Bankers express NWC as a percentage of revenue for projection purposes. If a company maintains NWC at 15% of revenue, and revenue grows from $1B to $1.2B, the implied NWC increase is $30M cash outflow.
Industry Variations
Retailers and manufacturers have high working capital needs due to inventory. Subscription software companies often have negative working capital because they collect payments upfront (deferred revenue). Negative working capital is desirable — the company is financed by its customers.
Working Capital in M&A
The purchase agreement includes a working capital peg — the expected NWC at closing. If actual NWC differs from the peg, the purchase price adjusts dollar-for-dollar. This prevents sellers from draining working capital before closing.
Cash Conversion Cycle
The cash conversion cycle quantifies working capital efficiency: CCC = Days Sales Outstanding + Days Inventory Outstanding − Days Payable Outstanding. A shorter CCC means faster cash conversion. Negative CCCs mean the company collects cash before paying suppliers.