A change in working capital is the difference in the net working capital amount from one accounting period to the next. A goal of management is to reduce any upward changes in working capital, thereby minimizing the need to bring in additional funding.
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.