In the Change in Working Capital component of the free cash flow formula, which items are included?

• A. Accounts receivable and inventory increases minus accounts payable and taxes payable
• B. Cash and cash equivalents
• C. Accounts payable and taxes payable
• D. Accounts receivable and accounts payable only

Answer: (A)

Change in working capital measures how much cash is tied up or freed due to changes in short-term assets and liabilities. It is basically current assets minus current liabilities, excluding cash and equivalents. In practice, you include accounts receivable and inventory because increases in these assets use cash, while you include accounts payable and taxes payable because increases in these liabilities release cash. The standard way to express this is ΔNWC = ΔAccounts receivable + ΔInventory − ΔAccounts payable − ΔTaxes payable. So, the item that best reflects this is including accounts receivable and inventory increases minus accounts payable and taxes payable. Cash and cash equivalents aren’t part of working capital, so they aren’t included in this calculation.