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Here's the formula for free cash flows I'll be referring to:

FCF = EBIT*(1-Tax Rate) + Depreciation and Amortization – Capital Expenditures – Increases in Net Working Capital (NWC)

If you have an increase in net working capital, you have more current assets than liabilities than you did in the previous period. So if you now have an increase in net working capital of, say, 10, why would you subtract this to get your free cash flow? Since current assets include cash, wouldn't you be subtracting an increase in cash (in some cases) from your free cash flow?

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An increase in working capital figure (current assets are greater than current liabilities) requires additional cash to be tied up in operations because an increase in current assets is a net outflow. In contrast, a decrease in working capital position means the firm has more cash available that can be used for other projects since an increase in current liabilities is a net inflow.

I hope this answers your question.

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  • $\begingroup$ What does it mean to tie up cash in operations? If it's cash, in excess of liabilities, why is it tied up? I hope that makes sense. $\endgroup$ – papercuts Dec 23 '17 at 21:11
  • $\begingroup$ I believe the clarification can best be found with the definitions. Free cash flow represents the cash that a company can generate after spending the money to maintain or expand its asset base. Net working capital is the aggregate of current asset and current liability and is a measure of the short term liquidity of a business. So when the current asset (which includes cash and cash equivalent) increases, it is tied to the short term liquidity of the business, which is what I mean by tied up in operations. I hope this helps. $\endgroup$ – RHO Dec 24 '17 at 3:42

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