Sign Up for Discounts
This form does not yet contain any fields.
    Sunday
    Aug042013

    What causes a change in working capital?

    A change in working capital is the difference in the net working capital amount from one accounting period to the next. Net working capital is defined as current assets minus current liabilities. Thus, if net working capital at the end of February is $150,000 and it is $200,000 at the end of March, then the change in working capital was an increase of $50,000.
    The business would have to find a way to fund that increase in its working capital asset, perhaps through one of the following financing options:
    • Selling shares
    • Increasing profits
    • Selling assets
    • Incurring new debt

    Here are a number of actions that can cause changes in working capital:

    • Credit policy. A company tightens its credit policy, which reduces the amount of accounts receivable outstanding, and therefore frees up cash. However, there may be an offsetting decline in net sales. A looser credit policy has the reverse effect.
    • Collection policy. A more aggressive collection policy should result in more rapid collections, which shrinks the total amount of accounts receivable. This is a source of cash. A less aggressive collection policy has the reverse effect.
    • Inventory planning. A company may elect to increase its inventory levels in order to improve its order fulfillment rate. This will increase the inventory investment, and so uses cash. Reducing inventory levels has the reverse effect.
    • Purchasing practices. The purchasing department may decide to reduce its unit costs by purchasing in larger volumes. The larger volumes increase the investment in inventory, which is a use of cash. Buying in smaller quantities has the reverse effect.
    • Accounts payable payment period. A company negotiates with its suppliers for longer payment periods. This is a source of cash, though suppliers may increase prices in response. Reducing the accounts payable payment terms has the reverse effect.
    • Growth rate. If a company is growing quickly, this calls for large changes in working capital from month to month, as the business must invest in more and more accounts receivable and inventory. This is a major use of cash. The problem can be reduced with a corresponding reduction in the rate of growth.
    • Hedging strategy. If a company actively uses hedging techniques to generate offsetting cash flow, there are less likely to be unexpected changes in working capital, though there will be a transactional cost associated with the hedging transactions themselves.

    Monitoring changes in working capital is one of the key tasks of the chief financial officer, who can alter company practices to fine-tune working capital levels. It is also important to understand changes in working capital from the perspective of cash flow forecasting, so that a business does not experience an unexpected demand for cash.

    Related Topics

    Working capital policies 
    Working capital productivity
    Working capital ratio
    Working capital turnover ratio 

    PrintView Printer Friendly Version

    EmailEmail Article to Friend

    Reader Comments

    There are no comments for this journal entry. To create a new comment, use the form below.
    Editor Permission Required
    You must have editing permission for this entry in order to post comments.