Why We Subtract the Change in Working Capital When Defining Cash Flows? A Pedagogical Note
7 Pages Posted: 12 May 2005 Last revised: 11 Jan 2015
Date Written: May 11, 2005
In this short teaching note I explain why we subtract the change in working capital from the proper item (Earnings before interest and taxes (EBIT) or Net income) in the Income Statement. I show in detail how departing from the sales revenues and the cost of goods sold we have to subtract the change in working capital. This explanation might be seen as unnecessary given it is a common practice. However, my experience in teaching this subject indicates that some additional explanations are needed.
Note: The Spanish version of this document can be found at http://ssrn.com/abstract=722259
Keywords: Cash flows, free cash flow, cash flow to equity, working capital
JEL Classification: M21, M40, M46, M41, G12
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