What's working capital and how does it affect free cash flow?

Working capital is the capital tied up in the short-term operating cycle of the business. Operationally: net working capital equals operating current assets minus operating current liabilities — typically accounts receivable plus inventory minus accounts payable, sometimes plus prepaid expenses minus accrued liabilities. We exclude cash and short-term debt because those are financing items, not operating.

The intuition: AR is cash you've earned but haven't collected. Inventory is cash you've spent but haven't realized. AP is supplier financing — cash you owe but haven't paid yet. Net working capital is the net amount the company has invested in funding its operating cycle.

The FCF impact is through the change in NWC. If NWC increases — AR grows faster than collections, inventory builds, AP doesn't keep pace — you've absorbed cash. That's a use of cash on the cash flow statement, and it reduces unlevered free cash flow. If NWC decreases — you collect faster, run inventory leaner, stretch payables — you release cash, and FCF goes up.

The formula: UFCF equals NOPAT plus D&A minus CapEx minus change in NWC. The change in NWC is current period NWC minus prior period NWC.

This matters a lot for fast-growing businesses. A company doubling revenue often has NWC growing in line — the absolute dollar absorption is massive, even at constant margins. That's why a fast-growing company can be GAAP-profitable but cash-flow negative. It's also why working capital efficiency is a real value-creation lever for sponsors: a 5-day improvement in DSO on a $1 billion revenue business releases roughly $14 million of cash, which is real money.

A practical point on modeling: I project NWC components as days outstanding ratios (DSO, DIO, DPO) tied to revenue or COGS rather than as percentages of revenue. That's how operators actually think about it, and it forces you to have a view on whether the business is improving or degrading on each lever.