How does an increase in net working capital affect free cash flow?

An increase in net working capital typically signifies that a company has invested more in its short-term assets, such as inventory and accounts receivable, than it has in its short-term liabilities. This investment means that more cash is tied up in the operational activities of the business.

Free cash flow is calculated as operating cash flow minus capital expenditures. When net working capital increases, it indicates that the company is using cash to fund its operations, which reduces the cash available for other uses, such as reinvestment, debt repayment, or returning to shareholders.

Thus, an increase in net working capital typically results in a decrease in free cash flow because more cash is absorbed in the company's day-to-day operations, leaving less available cash flow after accounting for expenses and capital expenditures. This dynamics lead to a downward pressure on the free cash flow metric as operational liquidity is constrained.