Working capital and the big five
How AR, AP, inventory, prepaid expenses, and accrued expenses move the statements — and why interviewers love them.
What is working capital?
Working capital is the difference between a company's current operating assets and its current operating liabilities. In plain English, it's the cash tied up in running the business day-to-day — collecting from customers, paying suppliers, holding inventory.
Cash, debt, and short-term investments are excluded even though they sit in "current" buckets on the Balance Sheet. They're financing items, not operational ones.
Why does this matter in interviews? Because almost every "walk me through the three statements" follow-up involves a change to a working capital line item. Master these five and you can handle any scenario they throw at you.
The big five items
1. Accounts Receivable (AR)
What it is: Revenue you've recorded on the Income Statement but haven't collected in cash yet. Think of it as an IOU from a customer.
AR goes up → You've delivered the product/service and booked revenue, but the customer hasn't paid you yet.
- IS: Revenue ↑, Pre-Tax Income ↑, Net Income ↑
- CFS: Net Income ↑, but AR increase is a use of cash (subtract in CFO)
- BS: AR ↑, Cash ↑ by less than the revenue amount, Retained Earnings ↑
- Net cash effect: Positive but smaller than the revenue amount
AR goes down → The customer finally pays you. No new revenue — it was already recorded.
- IS: No change
- CFS: AR decrease is a source of cash (add in CFO)
- BS: AR ↓, Cash ↑
If an interviewer says "Accounts Receivable increases by $100," ask whether there's a corresponding revenue increase. If yes, walk through both. If they just want an AR increase with no revenue change, it means the company already recorded the revenue but hasn't collected the cash — so only the BS and CFS change.
2. Accounts Payable (AP)
What it is: Expenses you've recorded on the Income Statement but haven't paid in cash yet. You received the invoice but the cheque hasn't gone out.
AP goes up → You've recorded the expense, reducing Net Income, but you're holding onto your cash for now.
- IS: Expense ↑, Pre-Tax Income ↓, Net Income ↓
- CFS: Net Income ↓, but AP increase is a source of cash (add in CFO)
- BS: AP ↑, Cash ↓ by less than the expense amount, Retained Earnings ↓
AP goes down → You pay the supplier. The expense was already recorded.
- IS: No change
- CFS: AP decrease is a use of cash (subtract in CFO)
- BS: AP ↓, Cash ↓
3. Inventory
What it is: Raw materials, work-in-progress, or finished goods sitting in a warehouse.
Inventory goes up → You purchased more inventory but haven't sold it yet. No expense hits the Income Statement because COGS is only recorded when inventory is sold.
- IS: No change
- CFS: Inventory increase is a use of cash (subtract in CFO)
- BS: Inventory ↑, Cash ↓
Inventory goes down → You manufactured and sold the goods. COGS increases on the IS.
- IS: COGS ↑ (and usually Revenue ↑ too — ask), Pre-Tax Income changes, Net Income changes
- CFS: Net Income changes, Inventory decrease is a source of cash
- BS: Inventory ↓, Cash changes, Retained Earnings changes
Purchasing inventory does not hit the Income Statement. Only when the goods are sold does the expense flow through as COGS. This trips up more candidates than almost anything else.
4. Prepaid Expenses
What it is: You paid cash upfront for something (e.g. an insurance policy, a 12-month lease) but the benefit hasn't been received yet, so it's not an expense on the IS.
Prepaid Expenses goes up → Cash out the door, but no IS impact yet.
- IS: No change
- CFS: Prepaid increase is a use of cash
- BS: Prepaid Expenses ↑, Cash ↓
Prepaid Expenses goes down → Now you recognise the expense on the IS.
- IS: Expense ↑, Pre-Tax Income ↓, Net Income ↓
- CFS: Net Income ↓, Prepaid decrease is a source of cash
- BS: Prepaid Expenses ↓, Cash ↓ (net of tax savings), Retained Earnings ↓
5. Accrued Expenses
What it is: Expenses you've recorded on the IS but haven't paid in cash yet — similar to AP, but used for recurring costs without invoices (salaries, utilities, rent).
Accrued Expenses goes up → You've recorded the expense, reducing Net Income, but haven't paid cash yet.
- IS: Expense ↑, Pre-Tax Income ↓, Net Income ↓
- CFS: Net Income ↓, Accrued Expense increase is a source of cash
- BS: Accrued Expenses ↑, Cash ↓ by less, Retained Earnings ↓
Accrued Expenses goes down → You pay the bill. Expense was already recorded.
- IS: No change
- CFS: Accrued decrease is a use of cash
- BS: Accrued Expenses ↓, Cash ↓
The universal pattern
Notice the pattern across all five items:
| What happens | Cash effect in CFO |
|---|---|
| Operating asset goes up (AR, Inventory, Prepaid) | Cash goes down (use of cash) |
| Operating asset goes down | Cash goes up (source of cash) |
| Operating liability goes up (AP, Accrued, Deferred Rev) | Cash goes up (source of cash) |
| Operating liability goes down | Cash goes down (use of cash) |
Assets up → cash down. Liabilities up → cash up. Reverse for decreases. This single rule handles every working capital question an interviewer can ask.
Deferred Revenue — the bonus sixth item
What it is: Cash collected from customers for a product/service you haven't delivered yet. It's a liability because you owe the customer that product/service, and when you deliver it you'll recognise expenses and pay taxes.
Deferred Revenue goes up → Cash in, but no revenue on the IS yet.
- IS: No change
- CFS: Deferred Revenue increase is a source of cash
- BS: Deferred Revenue ↑, Cash ↑
Deferred Revenue goes down → You deliver the product/service and now recognise the revenue.
- IS: Revenue ↑, Pre-Tax Income ↑, Net Income ↑
- CFS: Net Income ↑, Deferred Revenue decrease is a use of cash
- BS: Deferred Revenue ↓, Cash ↑ (net), Retained Earnings ↑
Because it implies future obligations — you still have to deliver the product, recognise expenses, and pay taxes on that revenue. A liability means "less future cash," and Deferred Revenue absolutely does that.
How to handle any working capital question in an interview
Follow this 4-step framework every time:
- Ask what changed and by how much — "Accounts Receivable increases by $100"
- Determine whether the IS is affected — Does it create new revenue/expense, or is it just a cash collection/payment?
- Flow through Net Income to CFS — Apply the asset-up/cash-down rule
- Update the Balance Sheet — Cash, the working capital item itself, and Retained Earnings (if the IS changed). Verify Assets = Liabilities + Equity
If you can do this calmly and methodically, you'll handle even the multi-step scenarios interviewers love to chain together.