Working capital has a deceptively simple definition: “Current assets minus current liabilities“. That is, working capital is the amount of a company’s assets that can be converted to cash in the near future, taking into account the payments that have to be made. The result is the amount of funds available for investment to generate new business.
It’s helpful to get a sense of what does and doesn’t have an effect on the amount of working capital available, because that can clarify the concept. The first aspect to notice is that any change involving only current accounts has no net effect on working capital. As an example: paying a $100 bill reduces a bank account — and therefore current assets — by $100. That also reduces accounts payable by $100, so there is no net effect on working capital.
Obviously, the components of working capital are changing constantly. Satisfying an account payable involves only current accounts, and there is no effect on working capital.
Similarly, when a customer sends a check for $200 to pay an invoice, you reduce accounts receivable by $200 and increase a bank account (even if only eventually via undeposited funds, another current asset) by $200. No change to total current assets, so no change to working capital.
It’s easy. Am I right? Well, those are changes to the current accounts. How about change to non-current accounts? Read on…
Changes To Non-current Accounts
If you have an algebraic turn of mind, you might consider the following sequence, beginning with the fundamental accounting equation:
Assets = Liabilities + Equity
Now, using these abbreviations:
- CA = Current Assets
- NCA = Noncurrent Assets [including both fixed and other assets]
- CL = Current Liabilities
- NCL = Noncurrent Liabilities, including long-term and other liabilities
We can get to an algebraic definition of working capital:
CA + NCA = CL + NCL + Equity
CA – CL + NCA = NCL + Equity
Working Capital + NCA = NCL + Equity
Working Capital = NCL + Equity – NCA
A change in the balance of a noncurrent account often, but not always, changes the amount of working capital.
So, as distinct from changes involving only current accounts, a change to a noncurrent account (a noncurrent asset, a noncurrent liability, or an equity account) can change the amount of working capital. If Lie Dharma Construction takes out a three-year loan for $15,000 and deposits the funds in a bank account for example, working capital increases by $15,000. The liability account that records the loan is a long-term liability, not a current liability. So current liabilities remain unchanged and both current assets and working capital increase by $15,000.
Of course, a company’s primary source of working capital in the long run is net income, the excess of revenues over expenses, and that’s the principal financial reason for being in business at all. From an accounting perspective, how do current assets such as inventory and accounts receivable get to be noncurrent, so that they affect working capital? Read on…
Let say you starts a new company called Lie Dharma Floors, a sole proprietorship, at the end of April and provides it with startup funds by depositing $25,000 in its bank account. At tyour point, the company has no liabilities, current or otherwise, and a current asset (and owner’s equity) of $25,000. The company’s working capital is therefore $25,000 at the outset.
You then records the following transactions:
- A deposit of another $15,000 from your personal funds into the company’s checking account, and also recorded as paid-in equity.
- The purchase of $28,000 in inventory for resale.
- The sale of $21,000 worth of inventory for $33,000.
- The receipt of $15,000 in payments from customers for their $33,000 worth of purchases. Those payments post first into Undeposited Funds, and then post into the company’s checking account. The total of the customers’ outstanding balances, $18,000, remains in accounts payable.
- The receipt of bills for the $28,000 worth of inventory from your vendors and the payment of $18,000, leaving $10,000 in accounts payable.
- You pay $8,500 in various operating expenses such as travel and communications.
- You also purchase a small, two-room office in a shopette for $22,000, paying for it with $15,000 in cash and $7,000 from a six-month bank loan.
- The withdrawal of $1,000 for your personal use, as an owner’s draw.
Upon finishing your ‘P&L’ and ‘Balance Sheet’ you would find the net income of $3,500 during May acts as a source of working capital.
On the balance sheet, the net income appears in Equity, a noncurrent account. $22,000 of current assets have been converted to fixed assets by the purchase of the office space. Current assets of $37,500 less current liabilities of $17,000 result in working capital of $20,500.
Lie Dharma Floors started out with $25,000 in working capital. It has earned $3,500 in net income. But its cash account has fallen to $12,500 and its working capital is down from $25,000 to $20,500.
How does this come about?
Looking into the matter helps you get a clearer understanding of how the company does business. Each transaction listed later has an effect on the amount of working capital available, subsequent to your initial $25,000 investment. You also see that none of the transactions involves solely current accounts. Other activities the company undertakes, such as purchasing inventory, are not listed because they involve only current accounts and therefore have no net effect on working capital.
- Your second investment increases working capital by $15,000 to $40,000.
- Product sales bring in $12,000 in gross profit, increasing working capital to $52,000.
- The company pays $8,500 in operating expenses, decreasing working capital to $43,500.
- A check for $15,000 is written as a partial payment for the office space. Working capital is now $28,500.
- Accounts payable is increased by $7,000 as a result of the short-term loan to pay the remaining balance owed on the office space. Working capital is $21,500.
- You withdraws $1,000 for your personal use, decreasing both your equity and working capital by $1,000, leaving working capital at $20,500.
So, after the initial investment of $25,000, various purchases, sales, and other transactions reduce the company’s working capital to $20,500. This amount agrees with the result of subtracting, on May 31, current liabilities from current assets. It’s obviously a lot quicker to do one simple subtraction than it is to trace every transaction during the period, particularly when a company typically has many more transactions than the six listed earlier.
This simple subtraction is informative, certainly — it’s the quickest way to determine working capital and therefore how it varies over time. But it doesn’t give you any real insight into how the company is carrying out the process of investing and disinvesting that creates profit (or loses it).
What Doesn’t Affect Working Capital
Transactions involving only current accounts have no net effect on the amount of working capital. That sort of transaction affects the components of working capital, of course, but not the result of subtracting current liabilities from current assets.
The same is true of noncurrent accounts. A transaction that does not involve a current account does not change the amount of working capital. An example is depreciation. Suppose your business owns a truck that it bought for $20,000. You keep it on your books as a fixed asset worth $20,000. But the truck loses value over time — that is, it depreciates — and you record that amount of loss periodically. The amount of loss you record is determined by which one of several methods for determining depreciation you and your accountant decide on.
That method might tell you to record $300 in depreciation for the first month your company owned the truck. You record $300 as a debit to an expense account, perhaps named Depreciation, and also as a credit to a fixed asset account, perhaps named Truck:Accumulated Depreciation. Neither account is a current asset account, therefore the transaction has no effect on working capital.
Although depreciation is recorded in expense and in fixed asset accounts, and thus does not affect working capital, it still needs to be accounted for when you’re calculating working capital. This issue is explained at the end of this post.
What Does Affect Working Capital
There are some transactions that are typical in the increase and decrease of working capital. Among them are the following:
- Net income. The sale of product for more than it cost to acquire the product is a typical source of working capital. But net income often must be adjusted before adding it in with other sources. The reason is that some expenses that are subtracted from gross profit to arrive at net income do not involve current accounts. In fact, one of the purposes of analyzing the sources and uses of working capital is to clarify the reasons for a difference between net income and working capital provided by a company’s operations.
- Acquisition of fixed assets. Buying equipment with cash, including cash obtained via borrowing, is a typical use of working capital. Acquiring the asset in exchange for stock involves no current account and has no effect on working capital.
- Paying off long-term debt. Assuming, as is usually the case that a company uses current assets to retire a long-term debt, paying off the debt is a use of working capital. A long-term debt is not carried in the current accounts payable liability account.
- Acquiring long-term debt. When a company takes out a long-term loan, the money borrowed goes into a current asset, usually a cash account. The company also acquires a noncurrent liability, the debt itself. Tyour transaction involves a current asset and a noncurrent liability, and is therefore a source of working capital.
- Selling a fixed asset. A company might occasionally sell equipment, a building, or even land in return for cash, because the company no longer has use for the asset or is in desperate need of funds. Tyour involves a current and a noncurrent account and is therefore a source of working capital. Suppose the asset is sold at a loss: A building purchased for $200,000 in 2005 is sold for $150,000 in 2009. Even though the sale represents a loss, it nevertheless increases working capital by $150,000.
Tracking Changes in Working Capital
It’s helpful to know that a company has increased — or decreased — its working capital from one period to the next. Knowing that is often more helpful than knowing the change in cash assets, or net sales, or even net income. But merely knowing that a company’s working capital increased by $103,355.59 during 2011 for example, doesn’t help you to understand how it’s being managed.
It’s good to know that the company has over a hundred thousand dollars more to work with, but whether you’re a potential employee, a manager, a stockholder, or creditor, you should want to know more.
What’s the main source of the increase in working capital?
- Long-term debt? Then maybe you should be extra careful about loaning the company more money.
- A recent stock issue? If newly floated shares were snapped up, maybe you should seriously consider the job offer they gave you.
- Net income? The only people who are unhappy when net income builds a company’s working capital are the short-sellers.
The notion of working capital focuses on assets that are available for use in the near term as well as liabilities that must be satisfied in the near term. It is the difference between the two amounts, so the amount of working capital is the company’s accessible assets less the near-term liabilities that it has already incurred. It is the amount of resources available to invest in new business, by converting cash to equipment, hiring additional staff, purchasing additional inventory, and so on.
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