How to Answer “How does working capital impact free cash flow?” in Investment Banking Interviews
In investment banking interview prep, a common cash flow question is: “How does working capital impact free cash flow?” Interviewers ask it because working capital movements can swing cash generation even when revenue and EBITDA look stable.
A strong answer ties the intuition to the mechanics: increases in operating working capital are a cash outflow that reduce free cash flow, while decreases release cash and increase free cash flow—then you show you can apply that logic quickly in cash flow analysis and modelling.
What Interviewers Look For in Working Capital Free Cash Flow
Interviewers are checking whether you understand the bridge from accrual accounting (income statement) to cash flow (cash flow statement). Specifically, they want you to explain why changes in receivables, inventory, and payables change cash—without getting lost in sign conventions.
They’re also assessing practical modelling fluency. In many financial modeling interview questions, candidates can recite “working capital affects cash flow,” but struggle to translate “DSO up” or “inventory build” into the correct direction and into a clean forecast.
Finally, they want judgement: whether you can interpret working capital as an operational story (collection efficiency, stock build, supplier terms) and connect it to valuation. Free cash flow drives enterprise value in DCFs, so recurring working capital needs (or one-off releases) matter for sustainable cash generation.
Answer Framework: Impact of Working Capital in Cash Flow Analysis
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Step 1: Define working capital and the FCF line you’re using
Start by stating what you mean by working capital, because definitions vary in interviews. In investment banking, it’s usually operating working capital: current operating assets minus current operating liabilities (commonly AR + Inventory + Prepaids − AP − Accrued expenses, excluding cash and debt-like items).
Then anchor the free cash flow formula you’ll reference. A standard unlevered definition is:
- FCF = EBIT(1−t) + D&A − Capex − ΔNWC
This makes the key point explicit: ΔNWC is subtracted, so it’s a use or source of cash that sits between operating profit and cash available to all capital providers.
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Step 2: State the rule and the intuition (use vs source of cash)
Give the rule in one line, then explain it in plain language:
- If operating working capital increases (ΔNWC > 0), free cash flow decreases (cash is tied up in the business).
- If operating working capital decreases (ΔNWC < 0), free cash flow increases (cash is released).
Intuition: working capital items represent timing differences between recognising revenue/expense and actually collecting/paying cash. If receivables rise, you’ve booked revenue but haven’t collected cash yet. If inventory rises, you’ve spent cash to buy/produce items not yet sold. If payables rise, you’re effectively financing operations by paying suppliers later—preserving cash today.
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Step 3: Break it down by driver (AR, Inventory, AP) with correct signs
Show you can do cash flow analysis at the line-item level:
- Accounts receivable (AR): AR up → cash collection lag worsens → FCF down. AR down → collections improve → FCF up.
- Inventory: Inventory up → cash spent on stock/build → FCF down. Inventory down → liquidation/reduced purchases → FCF up.
- Accounts payable (AP): AP up → you delay payments → FCF up (a source of cash). AP down → you pay down suppliers → FCF down.
A quick way to avoid mistakes is to ask: “Did cash leave the company or stay longer?” and map that to FCF. Then, if relevant, mention that other operating current items (accruals, deferred revenue) work the same way—timing impacts cash.
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Step 4: Add an interview-friendly mini example and a modelling sanity check
Offer a short numeric example to prove you can apply it. For instance, if EBIT(1−t) is 100, D&A is 20, Capex is 30, and ΔNWC is +15, then FCF = 100 + 20 − 30 − 15 = 75. If instead ΔNWC is −15 (a release), FCF becomes 105.
Then show a modelling sanity check used in financial models: when a company is growing, working capital often builds (especially AR and inventory), which can make FCF lag EBITDA. Conversely, in a slowdown or a deliberate efficiency programme, you may see a working capital release that temporarily boosts FCF—important to treat as potentially non-recurring when thinking about valuation.
Sample Answer for Financial Modeling Interview Questions (Analyst)
Working capital impacts free cash flow through the change in operating working capital, which is a use or source of cash. In an unlevered free cash flow build, it’s typically FCF = EBIT(1−t) + D&A − Capex − ΔNWC, so increases in working capital reduce FCF and decreases increase FCF.
Intuitively, working capital is about timing. If accounts receivable goes up, you’ve recognised revenue but haven’t collected the cash yet, so cash is tied up and FCF goes down. If inventory goes up, you’ve spent cash to buy or produce stock that hasn’t turned into sales yet, so FCF goes down. On the other hand, if accounts payable goes up, you’re paying suppliers later, which preserves cash in the period and FCF goes up.
For a quick example, if the business has EBIT(1−t) of 100, D&A of 20, and Capex of 30, then with ΔNWC of +15 the free cash flow is 75. If working capital instead releases 15 (ΔNWC of −15), FCF increases to 105.
In modelling and in investment banking, I also sanity-check that fast growth often requires a working capital build, so FCF can trail EBITDA, while one-off working capital releases can temporarily inflate FCF and shouldn’t be assumed permanent.
- Lead with the rule: ΔNWC up is a cash outflow; ΔNWC down is a cash inflow.
- Name the components (AR, inventory, AP) and get the direction right for each.
- Use one quick numeric example to demonstrate you can apply it under pressure.
- Add a judgement point: growth often consumes working capital; releases can be non-recurring for valuation.
Common Pitfalls When Explaining Working Capital Movements
- Using a vague definition of working capital (e.g., including cash or debt) and then getting the mechanics wrong.
- Mixing up the signs—especially with payables (AP up is usually a source of cash).
- Explaining it only with formulas and not with the timing intuition (collecting vs paying).
- Treating a working capital release as sustainable without noting it can reverse as operations normalise.
- Ignoring that the question is usually about *operating* working capital, not total current assets minus total current liabilities.
- Overcomplicating with too many edge cases instead of nailing AR/inventory/AP first.
Follow-Ups in Investment Banking Interview Questions on Cash Flow
How do you calculate change in net working capital in a model?
Forecast each operating working capital line (often using DSO/DIO/DPO or percent of sales/COGS) and take the period-to-period change; subtract ΔNWC in the cash flow build.
Why can a growing company show negative free cash flow even with strong EBITDA?
Growth can require more receivables and inventory, creating a working capital build and higher reinvestment, which reduces free cash flow despite healthy operating profit.
How does working capital affect valuation in a DCF?
Working capital changes directly affect forecast free cash flows; sustainable working capital needs reduce steady-state FCF, while temporary releases should be normalised to avoid overstating value.
Which working capital item is most important for a retailer vs a software company?
Retailers are often inventory- and payables-driven, while software businesses may be driven more by receivables and deferred revenue dynamics (if present) than physical inventory.
If DSO increases, what happens to cash flow and what might cause it?
FCF decreases because receivables rise; causes can include weaker collections, looser credit terms, customer mix shift, or billing disputes/timing.
How to Practise Working Capital and Free Cash Flow Explained
- Practice saying the one-line rule out loud: ΔNWC up → FCF down; ΔNWC down → FCF up. Then immediately translate it to AR/inventory/AP.
- Drill 5 quick scenarios (e.g., “inventory up”, “payables down”, “DSO improves”) and answer with direction + one operational reason.
- In a mock, force yourself to give a 20-second snippet first, then add the numeric example only if prompted.
- When reviewing a case study or model, reconcile EBITDA-to-CFO: point to the working capital lines that explain the difference.
- Use AceTheRound to simulate analyst-level follow-ups where the interviewer changes one assumption (DSO/DPO/turns) and you restate the FCF impact cleanly.
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