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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
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    $\begingroup$ 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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For acquisitions, NWC is current operating assets (excluding cash because it is a non operating asset) less current operating liabilities (excluding debt and debt like liabilities - which are non operating liabilities). In other words it's calculated on a cash free, debt free basis (common practice at Big 4 accounting firms). This calculation will give you the amount of cash that is required to operate the core business at a given time. Taking it one step further, if you normalize that amount over a historical period, it will tell you on avg. how much capital is required to operate the core business. Looking at it this way, I think it's a lot easier to see why NWC is subtracted in the equation to reach FCF. As noted above FCF is FREE cash flow, so that money is free to be used in any way the business operators see fit (dividends, stock buybacks, investing in projects, etc.) - Thanks!

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