Working capital is widely misunderstood


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).

Adapted from the Colour Accounting Learning System by Wealthvox.

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.

Phenomenon-based learning

Accounting Cafe online seminar on 19 November 2021

Liz Marsland, Queensland University of Technology (45 mins)

Liz Marsland is a trailblazer in phenomenon-based learning. She unpacks the methods, the challenges and the benefits to students and teachers in using this multi-disciplinary approach that has wide application across subject areas and throughout educational levels.

Elizabeth Marsland, CPA SHEA from Queensland University of Technology is a renowned TEDx speaker on phenomenon-based learning. She is passionate about innovation in accounting education.


Liz’s presentation (PPTX)

Zoom recording (45 mins)

Jenni Rose, Alliance Manchester Business School (44 mins)

Jenni Rose shares her experiences of teaching accounting through the lens of climate change. She challenges students to think about how accounting should be changed for the future and how climate change accounting works with formative and summative assessment.

Jennifer Rose, FCA BFP PGCert SFHea CMBE, senior lecturer in accounting, is the 2020 recipient of Teacher of the Year in the University of Manchester Distinguished Achievement Awards.


Jenni’s presentation (PPTX)

Zoom recording (44 mins)

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Recording (45 mins): Liz Marsland — Phenomenon-based learning

Recording (44 mins): Jenni Rose — Teaching accounting through the lens of climate change

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The nature of equity

Of the five financial statement elements, equity is the most mercurial. In part, because it’s a function of recognised assets less recognised liabilities, simply expressed in this form of the accounting equation.

Assets – Liabilities = Equity (net assets)

It’s this residual aspect of equity that makes balance sheets balance. They balance because equity is the balancing amount. As such, equity has no recognition criteria—the recognition criteria that are applied to assets and to liabilities determine the value of equity.

The derivation of equity, however, says nothing of its inherent nature. So, let’s start with a quick one liner:

Equity is not valuable. It is an obligation.

This is not how equity is defined in the conceptual frameworks of FASB and the IFRS. Their definitions, however, are problematic because they are not consistent with their definitions of assets and liabilities.

The definitions differ in some details but both FASB and the IFRS describe assets as the rights of the entity. Likewise, liabilities are defined as the obligations of the entity. The standing point is clear. These elements are defined as rights and obligations of the reporting entity.

When it comes to equity, however, the standing point moves. FASB defines equity as the residual interest of the owners in the net assets of the entity [1], while the IFRS defines equity as claims on the residual interest in the assets of the entity after deducting all its liabilities [2]. Equity is defined not from the point of view of the entity, but investors.

Being aware of this is important when teaching. Consistency of approach and careful use of language will help students to achieve a deeper understanding, faster.

Some of those with prior accounting knowledge come to class with a clear notion that equity is “the money invested by shareholders”. It isn’t—cash is the money invested by shareholders, and cash is an asset. This notion of equity collapses accounting duality in the same way that cash sales does, which we discussed in The nature of income.

So, what is equity?

Early on in our elementary accounting courses we show students this picture and ask them what My Supermarket Limited is worth.

Adapted from the Colour Accounting Learning System, ©Wealthvox [3] (Download as PowerPoint slide)

The answer, as always, depends on point of view. Some students suggest £50,000 because that’s the value of its assets, but the question is asking the worth of the entity, not the assets.

The most common answer is £20,000 because that’s the value of net assets and, of course, equity. This assumes, however, that the question is about the worth of the business from the shareholders’ point of view. Prompt students to consider the lender’s viewpoint and they’re more likely to suggest that the answer is £30,000, the recoverable amount of the loan.

The purest answer is that, from the entity’s point of view, it is worth nothing. The value of assets is always equivalent to the total of liability and equity claims. This, after all, is what the accounting equation tells us.

In the article on teaching liabilities, the point was made that my liability is your asset. If I have an obligation to you, then you have rights you can enforce against me. My promise to repay you the money that you lent me is mirrored by your right to collect that money from me.

Admittedly, shareholders do not have the same set of rights as lenders and creditors, but they do have identifiable claims. Quoting FASB again, “Owners invest in a business enterprise with the expectation of obtaining a return on their investment…” [4].

It is rational and consistent, therefore, to define equity as the entity’s obligation to meet those expectations. It’s all about point of view. The owner has rights and therefore the entity has an obligation to the owner.

Accounting regulators appear not to have noticed their inconsistency of approach and can become a little cranky if you point it out, but hold your ground—equity has different characteristics to liabilities, but, from the entity’s point of view, it’s an obligation and is not valuable.

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References

1. FASB (1985) Statement of Financial Accounting Concepts No. 6, paragraphs 49 and 60

2. IFRS (2018) Conceptual Framework, paragraph 4.63

3. Wealthvox (2020) Colour Accounting Learning System

4. FASB (1985) Statement of Financial Accounting Concepts No. 6, paragraph 51


Resources

PowerPoint slide (180KB) of illustration above. Free to use in teaching.