Working capital adjustments and how to handle them

Question

Hi there,

in M&A and valuation models, I consistently mess up how to treat changes in working capital. I’ve read multiple guides and tried memorizing rules, but in practice (like mock interviews), I either miscalculate it or don’t catch how it’s affecting cash flow. Are there frameworks or mental models people use to make this second nature?

Thanks for your help!

Answer 1

No worries, this trips up a lot of people early on. A simple mental model: if working capital increases, cash goes down (you’re tying up more money in the business); if it decreases, cash goes up (you’re freeing up cash). Focus on the change in working capital, not the absolute values.

Keep practicing with short drills (e.g., just model working capital impacts), not just full LBOs or DCFs. That helps it click faster.

Answer 2

At its core:

Working Capital = Current Assets (excluding cash) – Current Liabilities (excluding debt)

Typical components:

Current Assets: Accounts Receivable (A/R), Inventory, Prepaid Expenses
Current Liabilities: Accounts Payable (A/P), Accrued Liabilities

Use this rule of thumb:

An increase in working capital uses cash (outflow). A decrease in working capital releases cash (inflow).

Here’s why:

Accounts Receivable ↑ → You sold something but haven’t been paid → Cash not received → cash outflow
Inventory ↑ → You bought more goods → Cash spent → cash outflow
Accounts Payable ↑ → You delayed paying suppliers → Cash retained → cash inflow