Working Capital

In practice, bankers distinguish between 'working capital' (all current assets minus all current liabilities) and 'net working capital' (NWC), which typically excludes cash and short-term debt. NWC focuses on operational items: accounts receivable, inventory, prepaid expenses on the asset side, and accounts payable, accrued liabilities, deferred revenue on the liability side. When building a DCF or LBO model, you project changes in NWC, not total working capital.

An increase in NWC is a use of cash; a decrease is a source of cash. If a company's accounts receivable grows from $50M to $70M, that $20M increase means the company earned revenue but hasn't collected cash — reducing free cash flow by $20M. Conversely, if accounts payable grows, the company is delaying payments to suppliers, which temporarily boosts cash. Fast-growing companies often have increasing working capital needs, which can cause free cash flow to lag net income significantly.

In M&A transactions, the purchase agreement typically includes a working capital adjustment. The buyer and seller agree on a 'target' or 'normal' level of working capital, and the purchase price adjusts dollar-for-dollar for any deviation at closing. If actual NWC is $5M above target, the buyer pays $5M more. This mechanism prevents sellers from stripping cash out by delaying collections or accelerating payments before the deal closes.

Current Ratio = Current Assets / Current Liabilities — above 1.0 is generally healthy. Quick Ratio = (Current Assets - Inventory) / Current Liabilities — a stricter test. Days Sales Outstanding (DSO) = AR / Revenue x 365. Days Payable Outstanding (DPO) = AP / COGS x 365. Days Inventory Outstanding (DIO) = Inventory / COGS x 365. Cash Conversion Cycle = DSO + DIO - DPO. A lower cash conversion cycle means faster cash generation.