Difference Between Cash Flow
And Working Capital
Businesses should analyze working capital in relation to cash flow.
Hunkar Ozyasar, Demand Media
Cash flow and working capital represent two critical measures of a company's ability to meet its financial obligations. Many companies generate a significant amount of profit, but insufficient cash. By analyzing cash flow and working capital, an owner can determine whether his small business is likely to face difficulties in paying upcoming bills.
Cash flow refers to the amount of cash the company generates within a specific period of time. Cash flow is almost never equal to net profit as companies tend to sell on credit and borrow money. Furthermore, the cash generated through sales can be reinvested into the business or other assets, such as real estate, stocks and bonds. Therefore, the accountant cannot simply compare the cash at hand at the beginning and end of the accounting period to determine the cash flow. Instead, the accountant prepares a special report, called the statement of cash flows.
Working capital is the difference between current assets and current liabilities. In accounting, the term "current" refers to assets that can be turned into cash or liabilities that are due in less than 12 months. Because both figures are stated in the balance sheet of a corporation, the calculation of working capital is a simple task. A large amount of working capital means that the assets of the company are more than sufficient to cover liabilities that are soon due. Negative working capital means the company cannot pay upcoming bills with the amount of money, soon-to-be collectible receivables and other assets that can be turned into cash on short notice that it holds.
The key difference between these two figures is that working capital provides a snapshot of the present situation, while cash flow is a measure of the company's ability to generate cash over a specific period of time. Monthly or quarterly cash flows will naturally be very different from the amount of cash generated over a 12-month period. As a result, working capital provides an excellent idea about how easily the company can pay immediate liabilities, while cash flow is more of a forward-looking measure. If the working capital is insufficient but cash flow is satisfactory, the company could generate sufficient cash if given enough time. If, however, creditors aren't willing to give enough time to such a company, it could easily go bankrupt.
Under normal circumstances, companies with high cash flow also have high working capital. However, several reasons can result in a divergence. Investing in equipment or facilities, paying debt acquired a long time ago and paying dividends to stockholders can drain cash and working capital even if the company has generated significant cash though regular activities. Borrowing money and raising cash, on the other hand, will add to the cash position as well as to working capital, even though the company is unable to generate much cash under ordinary circumstances.
About the Author
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.