Okay, so from what I understand, changes in working capital is used to reconcile the net income (after adding back non-cash expenses) into cash from operations. For example, if Accounts Receivable goes up that means people have been purchasing on credit and thus cash goes down. Conversely if AR goes down, that means people have been paying off dues and thus cash goes up.
but what I DONT understand is inventory.
if inventory goes up (from the balance sheet), then cash drops. This sorta makes sense because that means more inventory was purchased. But if inventory decreases, then cash should go up.
That's what I don't understand. I've read that it means inventory has been sold, but isn't that already reflected in revenue, then reflected in net income, and thus already reflected in the cash flow statement at the top with net income?
I guess it's the same for if inventory goes up. isn't it already accounted for in COGS--> net income ---> cash flow statement.
Am I misunderstanding something here??
From what I remember, a sale of merchandise requires two separate entries: CREDIT sales, DEBIT cash (alternatively, you would do AR/AP entries instead if they aren't paying cash) CREDIT inventory, DEBIT COGS You can work out from there how your reasoning is faulty under those assumptions. The proper offset for inventory isn't cash, it's COGS.
Someone feel free to correct me if I'm completely wrong :/
This is correct.
You're confusing yourself, I think. If inventory goes down, that typically means there is a sale (unless it's a write-off of missing inventory, obsolete inventory, etc.). You get revenue from a sale, either as cash or AR. As a result, a decrease in inventory will typically eventually result in an increase in cash, but it may not be a direct cash payment.
Basically if inventory goes down, that was reflected in the expense and lowered your net income, however, you didn’t spend cash because you already had the asset. So you sell 5 bucks of inventory for 10 bucks, pretend there’s no other factors, you have a net income of 5 bucks, inventory went down 5 bucks, but cash flow is positive 10.
So there are two parts when accounting for (1) buying inventory and (2) selling inventory.
(1) when you purchase inventory for $10 cash, you working capital increases by $10 and thus you have a decrease in cash flow of $10. (NO change to the income statement)
(2) when you sell that inventory (assume you are paid $20 cash), your revenue is $20. you COGS for that sale is the $10 of inventory you already paid cash for, but you are recording it as an expense now because it has been sold. Say there is no tax - so net income is $10. In your cash flow, the decrease in working capital of $10 increases your cash flow by $10 for a total positive cash flow of $20.
Logically, this should make sense because in part (2) you really did receive $20 in cash. The cash you purchased for the inventory sold was already accounted for in part (1).
^part 1 is wrong. working capital stays the same because a purchase of 10 dollars worth of inventory is just converting one current asset to another, and therefore total current assets stay the same.
Earum provident consequatur occaecati non odit amet repellat. Occaecati sunt deserunt deserunt dolores.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...