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Working capital adjustments and how to handle them

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!

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Top answer
on Jun 13, 2025
JPMorganChase | CFA® Charterholder | IIFT Delhi (MBA Silver Medalist, Rank-2) | BITS Pilani | DPS (Gold Medalist)

Yeah, this is one of those sneaky things that doesn’t feel hard until you’re under pressure, and suddenly it feels like a mental fog. You’re definitely not alone—working capital is one of the most common tripping points, especially in M&A and valuation settings where you’re juggling a lot at once.

So here’s how to make it more natural. Forget the rules for a minute and just think of working capital as how much cash is tied up in the day-to-day stuff—like customers not paying you yet, inventory you haven’t sold, or bills you haven’t paid.

The way to build instincts around it is to stop thinking of it as an accounting adjustment and start treating it like you’re running the business. Imagine you’re the CFO.

If accounts receivable goes up, it means you made sales but haven’t gotten paid yet. That’s cash you don’t have. If inventory goes up, you bought stuff that you haven’t sold yet—again, cash is sitting in a warehouse. If accounts payable goes up, you’re delaying paying your suppliers, so you’re holding on to cash longer.

So when working capital goes up overall, it’s usually bad for cash. When it goes down, it frees up cash. That’s really the entire logic. You just have to see which direction the line items are moving and ask, “Is this helping or hurting my cash flow this period?”

When you’re building or reviewing a model, always slow down and look at the year-over-year change, not the absolute values. This helps your brain focus on the flow. Like, okay—AR went from 100 to 120, that’s a 20 increase, meaning you’ve tied up 20 more in cash this year.

If you're in a mock interview and someone throws a working capital question at you, take a second, think like a business owner, and walk through the cash logic out loud. That’s way better than trying to recall a formula under stress.

Also, if you really want to internalize it, pick a company and read through its cash flow statement over a few years. Every time working capital changed, try to explain to yourself why. Doesn’t need to be perfect—just get used to tying business activity to cash impact. After a few reps like that, it becomes muscle memory.

Simon
Coach
on May 23, 2025
Mastering Deals and Strategy | Seasoned coach

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.

Binika
Coach
on Jun 21, 2025
9+ years in Finance, Consulting and Strategy, Corporate Development|Accenture| Coach Finance Candidates to Ace Interview

Hey There!

A simple and reliable way to think about working capital in M&A and valuation models is to treat it as a short-term use or source of cash. If working capital increases, more cash is tied up in the business, which reduces free cash flow. If it decreases, cash is released, which boosts free cash flow. Instead of memorizing definitions, try to visualize what’s actually happening in the business. For example, if accounts receivable rise, the company hasn’t collected cash yet, even if revenue has been booked.

Focus on the core components: accounts receivable, inventory, and accounts payable. Ask yourself: are customers paying faster or slower? Are suppliers being paid earlier or later? Is inventory being managed efficiently? These drivers directly influence cash needs. In interviews, walk through the impact logically and explain how working capital movements link back to the cash flow statement. Practicing this thought process across different scenarios will help make it more intuitive over time.

Nitesh
Coach
on May 24, 2025
9+ yrs of work ex in finance/consulting - Barclays/ x-Citi. 500+ hrs coaching exp. MBA IIM Ahmedabad, Engg IIT Kharagpur

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
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