Working capital is a widely used but often misunderstood term. To teach it well, the term needs careful scrutiny.
The problem starts, as it usually does, with language.
“Working” isn’t helpful—we don’t have non-working capital, but working capital suggests that it works and the rest of capital doesn’t.
“Capital” is ambiguous and slippery—if you hear someone say capital be sure to find out what they mean before making assumptions. ‘Capital expenditure’, ’share capital’, ‘return on capital’ and ‘working capital’ are common accounting terms but each has a different meaning. Not nuanced quibbles over interpretation, but big whacking differences.
Depending on context, capital variously refers to one part of equity, all of equity, all of equity and liabilities, just liabilities, just non-current liabilities, just financial liabilities, or some combination of those. Oh, and in one case it means the acquisition of non-current assets.
Ask a banker or an economist and a slew of additional possibilities will open up. And we haven’t even started on ‘natural’, ‘social’, ‘human’, ‘manufactured’, ‘intellectual’, or ‘emotional’ capitals.
In classes, my students are required to consider the origins of working capital and then I give them an alternative method of calculation.
Working capital originates from a calculation used by bankers to indicate how much of their long-term lending is being used to fund current assets.
Working capital refers to non-current obligations
A functional explanation will make this clear but let’s first look at the traditional way of determining working capital—calculating net current assets.
Net current assets
Working capital rests on the notion that different sources of funding are allocated to specific types of assets in a specific order.
This is different to the principles that some creditors have security over assets; or that in a winding-up some creditors take precedence over others; and that all creditors take precedence over shareholders.
There is an implication that current liabilities are a source of funding for current assets. This is a dubious notion, which we’ll come back to, but for the moment let’s assume that to be the case.
In the figure below Pear Inc.’s current assets are greater than its current liabilities, so it has net current assets of $10 ($50 – $40).
This suggests that current liabilities are insufficient to fund the total value of current assets, so Pear Inc. requires additional funding—working capital—of $10. Self-evidently, this has to be non-current liabilities, equity or both, depending on the notional allocations of the remaining sources of funds.
A banking perspective
From a banker’s perspective, total long-term sources of funding are $330 (equity of $160 + non-current liabilities of $170). The banker determines that long-term funding is first allocated to non-current assets—$320 in this case. Long-term funding exceeds non-current assets by $10 ($330 – $320), and that excess is working capital, as it is funding net current assets.
I prefer this calculation as it suggests working capital is an obligation:
( Equity + Non-current liabilities )
– Non-current assets
In reality, however, sources of funds are not linked or allocated to uses of funds—there are assets and there are liabilities and equity. There is cash and there is a bank loan. There is inventory and there are accounts payable.
Assets and liabilities are classified between current and non-current (interestingly, defined differently for assets and liabilities), but classification does not create a link between types of assets and obligations.
Arguably, stewardship requires an eye to be kept on their respective amounts, but the balances sit there without belonging to each other.
The current ratio
The current ratio, because it is based on the same notional allocations of current assets and current liabilities, presents similar problems.
No ratio on its own can tell a story, but together with corroborating data and context, the current ratio may indicate an entity’s ability to meet its liabilities as they fall due, i.e, its liquidity (and ultimately, possibly its solvency too).
The reasoning is that if current assets exceed current liabilities, short-term creditors (suppliers, for example) are exposed to less risk.
Pear Inc. has a current ratio of 1.25 (Current assets $50 / Current liabilities $40).
Working capital requirements vary considerably by business type. If high levels of inventory are necessary, for example a whisky distiller, the working capital requirement will be greater than that of a business where inventory turns more quickly, such as a food retailer.
A current ratio of 2 or more may be a sign of rude health, or it could be that the company has built up inventory that can’t be sold and its current liabilities are falling due. Such a scenario could spell disaster for the creditors.
A companion ratio, the “quick ratio” or “acid test” excludes inventory from current assets in the calculation, but that’s not necessarily a safe bet either.
In September 2021, Nestle, the Swiss food giant, shows that it has current liabilities greater than its current assets—net current liabilities—giving a current ratio of 0.8 and a quick ratio of 0.5. Don’t rush to short the stock—nobody’s worrying about getting paid. Nestle has the operational strength and market power to muscle suppliers and other short term creditors into providing funding for its non-current assets. That’s what a current ratio of less than one means. Net current liabilities are available to fund non-current assets.
The current ratio is just one part of the story and not even tentative conclusions can be drawn without understanding the context and other available facts. There are multiple factors to consider (sector, growth, credibility, profitability) but none matters more than point of view.
- An unsecured creditor, a supplier for example, will be reassured by a high ratio.
- A bank, whose purpose is to earn money from lending will, up to a point, want to provide working capital. So, lenders benefit from higher current ratios.
- Investors, however, know that there is a financial benefit to them if current liabilities are a cheaper source of funding than longer-term liabilities, so a current ratio of less than 1, up to a point, may be welcomed.
Despite what texts might say, there is no such things as an ideal current ratio. Whatever the current ratio is, it does not tell you if the business is a safe bet or about to go bust, or whether its managers are good stewards, reckless or overly cautious.