Tripping up on a simple concept: why does cash ALWAYS decrease when liabilities increase (and vice versa)? Believe this should only apply when considering Operational BS items (A/R, A/P, Accrued Expense, etc). I understand each item, how inc/dec in each flow through financial statements, but really missing the intuition and implications behind this. Thank you so much.
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It doesn't? When liabilities increase from one period to the next, such as when debt rises, this represents a cash inflow. Think about it logically; all "debt" is just cash. A term loan, a liability for the company, is just cash, an asset for the company. When the debt is taken on, the debt increases, and there's an inflow of cash.
It's the same thing for operational line items; for inventory, when it increases, it means the company converted their cash into materials to sell, which means cash went down since they had to purchase the assets.
If thinking about NWC, think about it this way: if liabilities increase, then the company “saved” cash by not paying them; if receivables increase, the the company “lost” cash because it didn’t collect those receivables
If you finance using debt/equity then there must be an asset offset (be it cash, plant, goodwill, etc.). If you retain earnings, same thing: equity increases, so too must an asset (cash probably or plant if it’s reinvested). That leaves us with change in net working capital. Earnings are determined using the matching principle which means we match revenue to incurred COGS, however that doesn’t mean cash came in/went out in the exact amounts as revenue recognition does not always require cash to have been received. Thus, retained earnings will impact equity and cash, but there will be an additional cash impact associated with change in working capital as the presence of income statement GAAP earnings does not inherently mean cash was collected.
Ie. If a company had $1M of AR and $1M of AP last quarter and reports $2M of AR and $2M of AP this quarter there will be no change to the cash balance as a result of working capital. There may be a change to cash balance of debt/equity was issued or if earnings were retained, but it won’t come from working capital. Thus, if liabilities increase cash does not ALWAYS increase if there was a equal/opposite increase on the asset side.
This is an oversimplification, there is a reason there are accounting departments.
Great response - really appreciate it. How would you answer the following Q in an interview?
(e.g., Imagine you just walked through how Prepaid Expenses [Asset] decrease by $10 flows through 3 Statements) Why does the Prepaid Expenses under CFO / Change in NWC section increase by $10 if Prepaid Expenses on the Balance Sheet decreased by $10?
if debt or equity increases, cash increases. then you use the cash to buy something but it itsn't accurate to say credit term loan debit pp&e. debit cash first. if debt or equity decreases, you paid it off with cash so cash decreases. not too hard
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