What is working capital and how does an increase affect cash flow?

Working capital is current assets minus current liabilities. In valuation and modeling I use operating working capital, which excludes cash and debt because those are financing items. So it is mostly accounts receivable, inventory and prepaid expenses, minus accounts payable, accrued expenses and deferred revenue.

An increase in net working capital is a use of cash. If receivables grow by $10M, the company booked revenue but has not collected that cash, so operating cash flow is $10M lower than net income would suggest. If inventory grows, cash went into stock sitting on shelves. Going the other way, if accounts payable grow, the company is holding onto cash longer before paying suppliers, which is a source of cash.

Working capital also tells you about the business model. A growing manufacturer with long customer payment terms needs more working capital every year, which eats into free cash flow. A retailer that collects cash at the register but pays suppliers in 60 days, or a software company billing annually upfront, can run negative working capital, so growth actually releases cash. In a DCF, I subtract the increase in NWC each year.