Working capital: why profit and cash disagree
“Accounts receivable goes up by $50. What happens to cash?”
Working capital is where profitable companies quietly run out of money. Interviewers want to see you reason about timing: booked versus collected, used versus paid.
Operating assets up = cash down. Operating liabilities up = cash up. Everything in working capital follows from that one rule.
What working capital actually is
Working capital is the cash tied up in running the business day to day: money customers owe you (receivables), goods sitting on shelves (inventory), money you owe suppliers (payables), and cash customers paid in advance (deferred revenue). Bankers usually exclude cash and debt and focus on these operating items.
The one rule, with intuition
When an operating asset grows, cash has been absorbed. You made a sale but are still waiting to be paid; you bought inventory you haven't sold. When an operating liability grows, cash has been freed: you got the supplier's goods but haven't paid yet; a customer prepaid for something you haven't delivered.
- 1Receivables up $30 → −$30 (sales not yet collected).
- 2Inventory up $20 → −$20 (cash spent on stock).
- 3Payables up $15 → +$15 (bills not yet paid).
- 4Deferred revenue up $5 → +$5 (cash received early).
Deferred revenue: the one people get backwards
A customer pays $120 today for a year of software. You have the cash, but you haven't earned it, so it's a liability: you owe the service. Revenue then gets recognized $10 a month as you deliver. Subscription businesses can therefore collect cash well before they show profit, which is why they love negative working capital.
“Is negative working capital bad?” Not necessarily. Retailers that get paid instantly but pay suppliers in 60 days, or software firms paid upfront, run negative working capital on purpose: customers and suppliers are financing them.
Predict it: up, down, or the same?
Say it like this
If accounts receivable goes up by $50, the company recorded $50 of revenue it hasn't collected yet. Net income already includes that revenue, so on the cash flow statement I subtract the $50 increase in receivables: cash from operations is $50 lower than net income. In general, when an operating asset increases it uses cash, and when an operating liability increases it's a source of cash.
Traps to avoid
- ✕Getting the sign backwards: an increase in an asset reduces cash.
- ✕Treating deferred revenue as revenue. It's a liability until the service is delivered.
- ✕Thinking negative working capital always means distress. It often means a strong business model.
What they'll ask next
›Why do fast-growing companies often burn cash?
Growth inflates receivables and inventory before customers pay, so working capital soaks up cash even when profits look healthy.
›How would you project working capital in a model?
Tie each item to its driver: receivables as days of revenue, inventory and payables as days of COGS, deferred revenue as a % of revenue. Then the cash flow statement picks up the change each year.
›What does a rising DSO tell you?
Customers are taking longer to pay. It ties up cash and can signal weaker customers or aggressive revenue recognition.
Check yourself
Accounts receivable increases by $20. What's the change in cash flow from operations?
Use a minus sign for a decrease.
Put it all together
Turn a year of real-world events into an income statement, a cash flow statement and a balance sheet that balances.