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Treatment of Net Working Capital
Changes in inventory, accounts receivable, and accounts payable are included in the cash flow
calculation but not in EBT. Changes in the components of working capital directly impact cash flow,
but they are not deductible for tax purposes. When a firm buys inventory, it has essentially swapped
one asset (cash) for another asset (inventory). Though this is a negative cash flow, it is not considered
a deductible expenditure for tax purposes.
Similarly, a rise in accounts receivable means that cash that otherwise would have been in the
company coffers is now owed to the company instead. Thus, an increase in accounts receivable
effectively sucks cash out of the company and must be treated as a cash outflow. Increasing accounts
payable has the opposite effect.
One way to gain perspective on the impact of accounts payable and accounts receivable on a
company‟s cash flow is to think of them as adjustments to sales and cost of goods sold. If a company
makes a sale but the customer has not yet paid, clearly there is no cash flow generated from the sale.
Though the sales variable will increase, the increase in accounts receivable will exactly offset that
increase in the cash flow computation. Similarly, if the company incurs expenses in the manufacture
of the goods sold but has not yet paid its suppliers for the raw materials, the cost of goods sold will be
offset by the increase in accounts payable.
Depreciation
According to a straight-line depreciation schedule, depreciation in each year is the initial cost of the
plant or equipment divided by the number of years over which the asset will be depreciated. So, the $8
million plant depreciated over 10 years generates depreciation of $800,000 each year. Land is
generally not depreciated. Straight-line depreciation is but one acceptable method for determining
depreciation of plant and equipment. The tax authorities often sanction other methods and schedules.
Windfall Profit and Windfall Tax
In order to compute windfall profit and windfall tax, we must be able to track an asset‟s book value
over its life. Book value is the initial value minus all previous depreciation. For example, the brewery
initially has a book value of $8 million, but that value falls $800,000 per year due to depreciation. At
the end of the first year, book value falls to $7.2 million. By the end of the second year, following
another $800,000 of depreciation, the book value will be $6.4 million. By the end of the tenth year,
when the brewery is fully depreciated, the book value will be zero.
Windfall profit is the difference between the salvage value and book value. We are told the beer
company will be able to sell the old brewery for $1.5 million at the end of 10 years. By then, however,
the book value of the brewery will be zero. Thus, the beer company will realize a windfall profit of
$1.5 million. The government will want its share of that windfall profit. Multiplying the windfall