Working Capital Explained: Accrual vs Cash Accounting

Working capital explained simply: working capital measures the short-term operating assets and liabilities needed to run a business, while accrual vs cash accounting explains why those balances exist in the first place. Net working capital is usually current operating assets minus current operating liabilities. In investment banking interviews, the version that matters most is operating net working capital: accounts receivable plus inventory minus accounts payable and accrued expenses. A rise in working capital is a use of cash because the company has tied up cash in receivables or inventory. A fall in working capital is a source of cash. This concept shows up everywhere: three-statement linkage, DCF forecasting, and even paper LBO shortcuts.

TL;DR

• Net working capital usually equals current operating assets minus current operating liabilities.
• Accounts receivable rising is a cash outflow because revenue was booked before cash was collected.
• Accounts payable rising is a cash inflow because expenses were recorded before suppliers were paid.
• Accrual accounting records revenue when earned and expenses when incurred, not when cash moves.
• If NWC rises by 15 dollars, free cash flow falls by 15 dollars.

What is working capital?

Working capital is the capital tied up in short-term operating accounts. Wall Street Prep defines working capital as current assets minus current liabilities, but bankers often narrow it to operating accounts when building models. Cash and debt are usually excluded from operating net working capital because they are financing or non-operating items, not part of the day-to-day revenue cycle. The most common operating formula is:

$\text{NWC} = \text{Accounts Receivable} + \text{Inventory} - \text{Accounts Payable} - \text{Accrued Expenses}$

This is the version that feeds unlevered free cash flow, because it captures whether growth consumes cash before it produces cash.

What is accrual vs cash accounting?

Accrual accounting records revenue when earned and expenses when incurred. Cash accounting records revenue and expenses when cash actually changes hands. Corporate Finance Institute's accrual guide gives the core idea: accrual accounting matches revenue and expenses to the period they relate to, even if cash collection or payment occurs later. Working capital is the balance-sheet evidence of that timing gap. Accounts receivable exists because revenue was recorded before cash collection. Accounts payable exists because an expense or inventory purchase was recorded before cash payment. The cash flow statement then reverses those timing differences to show actual cash generated.

How does working capital affect cash flow?

An increase in working capital reduces cash flow. A decrease in working capital increases cash flow. The reason is practical, not abstract. If accounts receivable rises, the company made sales it has not collected in cash. If inventory rises, the company bought or produced goods before selling them. Both consume cash. If accounts payable rises, the company delayed paying suppliers, preserving cash for now. In a DCF, change in NWC is subtracted from cash flow:

$\text{FCF} = \text{NOPAT} + D\&A - \text{Capex} - \Delta \text{NWC}$

That minus sign is the interview trap. Positive change in NWC is a cash outflow.

Account increases	Cash flow effect	Why
Accounts receivable	Down	Sales booked before cash collected
Inventory	Down	Cash tied up in unsold goods
Accounts payable	Up	Supplier payment delayed
Accrued expenses	Up	Expense recorded before cash paid

What is a worked example?

Suppose revenue grows from 100 dollars to 130 dollars. Accounts receivable rises from 20 dollars to 30 dollars, inventory rises from 15 dollars to 22 dollars, accounts payable rises from 12 dollars to 16 dollars, and accrued expenses rise from 5 dollars to 6 dollars. Old NWC was 20 plus 15 minus 12 minus 5, or 18 dollars. New NWC is 30 plus 22 minus 16 minus 6, or 30 dollars. Change in NWC is 12 dollars. Even if net income improved, free cash flow is 12 dollars lower than it would have been because growth required more operating capital.

Why does this matter in IB interviews?

Working capital is where candidates reveal whether they understand accounting beyond formulas. Interviewers ask what happens if accounts receivable rises by 10 dollars, why deferred revenue can be a cash inflow, or why fast-growing companies can show weak cash flow. The answer is always timing. The income statement recognizes business activity under accrual rules. The cash flow statement adjusts back to cash. Working capital is the bridge between those two views. That is why it sits between basic accounting and advanced valuation topics like WACC, DCF, and LBO returns.

Frequently Asked Questions

Is cash included in net working capital?

In textbook current assets minus current liabilities, cash is included. In operating models, bankers usually exclude cash because it is not an operating working-capital account. The operating version focuses on receivables, inventory, payables, and accruals.

Why is an increase in accounts receivable bad for cash flow?

Accounts receivable increases when revenue has been booked but cash has not been collected. The income statement shows the sale, but the company is still waiting for cash, so operating cash flow is lower.

Why is an increase in accounts payable good for cash flow?

Accounts payable increases when the company has recorded a purchase or expense but has not paid the supplier yet. Delaying payment preserves cash temporarily, so it is a source of cash.

What is the difference between working capital and change in working capital?

Working capital is the balance at one date. Change in working capital is the period-over-period movement. Free cash flow uses the change, not the ending balance.

How do you forecast working capital?

Common approaches include days sales outstanding for receivables, days inventory outstanding for inventory, and days payable outstanding for payables. Simpler interview models often use NWC as a percentage of revenue.

Sources

• Wall Street Prep, "Working Capital": https://www.wallstreetprep.com/knowledge/working-capital/ (checked July 2026)
• Corporate Finance Institute, "Accrual Accounting": https://corporatefinanceinstitute.com/resources/accounting/accrual-accounting-guide/ (checked July 2026)
• Corporate Finance Institute, "The 3 Financial Statements": https://corporatefinanceinstitute.com/resources/accounting/three-financial-statements/ (checked July 2026)