The working capital flow or fund arises when the net effect of a transaction is to increase or decrease the amount of working capital. Normally, a firm will have some transactions that will change net working capital and some that will cause no change in net working capital. Transactions which change net working capital include most of the items of the profit and loss account and those business events which simultaneously affect both current and non-current balance sheet items. On the other hand, transactions which do not increase or decrease working capital include those which affect only current accounts or only non-current accounts. Let us take examples to illustrate the concept of the flow of working capital.
Suppose that a company issues ordinary shares for cash. Two accounts are involved in this case— the cash account, which is a current (asset) account and the share capital account, which is a non-current account. The company receives cash against the owners’ increased claims. Thus, there occurs a net increase in working capital.
A company purchases machinery for cash; again two accounts—the cash account, which is a current (asset) account and the machinery account, which is a non-current (asset) account—are affected. The company acquires a fixed asset by paying cash. This has the effect of decreasing working capital.
Some transactions do not change working capital. For example, if a company receives cash from its debtors, it represents increase of cash— a current asset account and decrease of debtors- again a current asset account. Thus, there will be no net change in the amount of working capital, although the composition of working capital will be affected.
If the company pays cash to its creditors, two current accounts will be affected. The cash account, being a current asset account, decreases and the creditors account, being a current liability account, also decreases. The net effect will be no net change in the working capital, although the composition of working capital will change.
Working capital will also not be affected if both the accounts involved are non-current. Suppose that the company purchases land and makes payment by issuing shares to the landowner. Both accounts are non-current in nature and do not at all affect current asset or current liability. There-fore, working capital will remain unaffected. Similarly, if the company converts loan or debentures into equity, it will have no effect on working capital.
In the profit and loss account the revenue items increase cash or receivables and, therefore, increase working capital; the expense items reduce cash or create current liabilities and, therefore, decrease working capital. But there are certain items in the profit and loss account that are non-current, and, thus they have no effect on the net flow of working capital. Depreciation is an exam-ple. It reduces fixed assets but does not increase or decrease working capital. Therefore, in determining the net flow of working capital from operations, the amount of depreciation is added to net profit to set right the effect of depreciation deduction.