What is a change in working capital?

Depending on the activities and financial decisions of the business there are quite a few ways that working capital can take a turn. Here are six common drivers:

1. Accounts receivable and accounts payable

When customers take longer to pay their invoices, it increases accounts receivable. While this technically raises current assets, it can hurt cash flow because the money isn’t readily available for the business to use. This delay reduces the liquidity of your working capital, making it harder to cover immediate expenses. 

On the flip side, accounts payable (the money you owe to suppliers) can also impact working capital. If you delay payments to suppliers, it temporarily boosts working capital because you’re holding onto cash longer. However, this can strain relationships with suppliers, possibly leading to less favorable terms in the future.

2. Changes in inventory

Inventory levels can have a big effect on working capital. When inventory increases, cash is tied up in goods that aren’t yet sold, reducing the liquidity of your assets. For example, overstocking products to prepare for seasonal demand can decrease working capital in the short term. But, efficient inventory management strategies, such as maintaining just-in-time inventory, can help minimize this impact by keeping stock levels aligned with demand. This approach ensures that cash isn’t unnecessarily locked away in unsold goods.

3. Business purchases

Business purchases such as buying raw materials, equipment, or other assets can quickly reduce working capital, especially if they’re paid for in cash. Look at buying new machinery outright, for example, this might boost operational capacity but also depletes cash reserves, lowering working capital. On the other hand, financing these purchases through credit or loans can delay the immediate impact on working capital, giving the business time to generate revenue before the debt comes due. This strategy can help maintain liquidity while supporting growth.

4. Loans or debt finance

Debt and loans are a two-sided coin. Taking on short-term loans can increase your current liabilities, which reduces working capital. Like borrowing to cover operational costs or investing in inventory may provide a temporary cash boost. But once you scan out to see the full picture, it ultimately impacts the balance sheet. Then again, paying off short-term debt decreases liabilities, improving working capital and reflecting better financial health. The bottom line is careful planning is needed to ensure that borrowing aligns with your business’s cash flow and repayment capacity.

5. External investors or cash injections

When investors give funds or when equity financing is obtained, it can boost working capital by adding cash to the business. This influx of funds can help cover expenses, reduce liabilities, or support expansion efforts. However, the reverse is also true: paying dividends to shareholders or distributing profits reduces cash reserves, thereby lowering working capital. Businesses must strike a balance between rewarding investors and maintaining enough liquidity to meet operational needs.

6. Business expansion

Business expansion, such as launching a new product line, hiring staff, or opening new locations, often requires upfront costs that reduce working capital. These expenses, whether for increased inventory, marketing, or infrastructure, tie up cash in the short term. However, successful expansions typically generate additional revenue over time, which can replenish working capital and support future growth. Planning and securing adequate funding are crucial to ensure that expansion efforts don’t strain the business’s cash flow.