Reporting Working Capital, Current Assets, Current Liabilities

Working capital

Typically, a company issues a classified balance sheet, which means it has several classifications (or categories) of assets and liabilities. The typical classifications are shown in this condensed balance sheet:

working-capital-exp02

The classified balance sheet allows users to quickly determine the amount of the company's working capital. Using the amounts from the above balance sheet, we have:

Working capital = $170,000 of current assets minus $100,000 of current liabilities = $70,000

A company's working capital must be managed so that cash will be available to pay the company's obligations when they come due. This is important for:

  • having a positive relationship with creditors, employees, and others
  • complying with the terms and conditions in a loan agreement
  • maintaining an excellent credit rating

The amount of working capital that is needed by a company depends on many factors. One factor is the company's size. For example, $70,000 of working capital could be sufficient for a company with current liabilities of $100,000; however, a larger company having current liabilities of $600,000 is likely to need more than $70,000 of working capital.

A second factor is the speed at which a company's current assets can be converted to cash. For instance, if a company has $170,000 of current assets but most of the amount is in slow-moving inventory, the company may not be able to convert the inventory to cash in time to pay the current liabilities when they come due. Not paying some obligations on time can have severe consequences.

A third factor influencing the required amount of working capital is the company's ability to borrow money. For example, a company with a preapproved line of credit that can be used when needed allows the company to operate with a smaller amount of working capital.

Other factors include the credit terms that are allowed by the company's suppliers, the company's profitability and growth rate, the time required to complete a customer's order, and more.

Current assets

An example of the current asset section of a balance sheet for a company selling goods on credit is shown here:

working-capital-exp03

The current assets are listed in the order in which they are expected to be converted to cash. Accountants refer to this as the order of liquidity. Since cash is the most liquid asset, it is listed first. (Large companies often expand the description to be cash and cash equivalents.)

Cash includes a company's currency, coins, petty cash fund, general checking account, payroll checking account, money received from customers but not yet deposited, etc. The $12,000 shown above as "Cash" is the sum of those items.

Temporary investments include short-term certificates of deposits and securities that can be readily converted into cash.

Accounts receivable – net is the amount that a company currently expects to receive from customers who purchased goods or services on credit. It consists of the amount the customers owe minus an estimated amount that will not be collected. To illustrate, let's assume that the general ledger account entitled Accounts Receivable has a balance of $54,000. (This is the company's sales invoices which have not yet been paid by the customers.) If the company estimates that $4,000 will never be collected, the account Allowance for Doubtful Accounts will report a credit balance of $4,000. The net of these two account balances is $50,000 ($54,000 minus $4,000) which is listed after cash and temporary investments.

Inventory (goods held for sale) is listed after accounts receivable since it usually takes many months for a company to convert its inventory into cash.

Supplies is similar to inventory. Supplies could include packaging materials, shipping supplies, etc.

Prepaid expenses often include annual memberships, annual service contracts, and insurance premiums that were paid in advance. To avoid paying in advance, a company may be able to arrange for automatic monthly charges.

Having the current assets listed in their order of liquidity gives the readers of the balance sheet some idea of the company's ability to pay its obligations when they come due.

Current liabilities

The following is an example of the current liabilities section of a company's balance sheet:

working-capital-exp04

As is the case with most amounts reported on the financial statements, the current liability amounts are the sum of the balances in many general ledger accounts. For example, the one line "Accrued expenses/liabilities 8,000" included above may be the sum of the balances in the following general ledger accounts:

  • Accrued Wages Payable
  • Accrued Payroll Taxes
  • Accrued Employee Fringe Benefits
  • Accrued Utilities Payable
  • Accrued Repairs and Maintenance
  • Accrued Advertising Expenses
  • Accrued Professional Fees Payable
  • Accrued Interest Payable

Interestingly, the current liabilities are not reported in the order in which they are due. In our example we listed the written promises first, accounts payable second, and then the remaining current liabilities. Another practice is to list the accounts payable first, the written promises second, and then the remaining current liabilities.

Since the current liabilities are not listed in the order in which they are due, a note payable that will be due in 11 months could appear first and the payroll taxes that are due in two days could be included in the fourth item.

Technology and working capital

Technology allows some companies to operate with less working capital than was needed in the past. Take for example a company that sells high demand products on its website with customers paying with credit cards at the time they place an order. The company will receive a bank deposit from the credit card processor within a few days of the sale. It is also possible that the company is allowed to pay its suppliers 30 days after receiving the products that will be sold in a few days.

Some companies use a business credit card to pay for the goods and services it receives. The company then has 27 to 57 days to pay the credit card company, depending on the date of the credit card statement.

These examples show how technology can speed up the conversion of a company's current assets to cash or how the company can delay the payment of cash for some purchases. Both will improve the company's liquidity without increasing the amount of working capital.

Accrual Method of Accounting

Under the accrual method (or accrual basis) of accounting the current asset accounts receivable is reported on the balance sheet when an amount has been earned. The amount earned is also reported as revenue on the income statement. When the company receives the money, accounts receivable will decrease and cash will increase.

Under the accrual method the current liability accounts payable (or accrued liabilities/expenses) is reported on the balance sheet when a liability has been incurred. If an expense is involved, the expense is also reported on the income statement. When the company pays the amount owed, accounts payable will decrease and cash will decrease.

Throughout this topic and in nearly all accounting textbooks, it is assumed that the accrual method of accounting is being followed. In short, the accrual method is the standard method to be used when financial statements are distributed to people outside of the company. (Income tax reporting may be different especially for small businesses.)

Changes in the Amount of Working Capital

A company's profitability is likely to be the most important influence on the amount of its working capital. A highly profitable company's operations may generate enough working capital that it can avoid the need for loans and/or additional money from investors.

In contrast, a company with significant operating losses may cause the company's working capital to shrink rapidly. A significant loss of working capital could result in violating existing loan agreements, being unable to obtain additional loans or attract investors, perhaps lose the ability to purchase goods with credit terms of 30 days, etc. Unprofitable business operations combined with the loss of working capital could jeopardize the company's ability to continue operating.

Since working capital is defined as current assets minus current liabilities, the increase or decrease in working capital will result from transactions outside of the current assets and/or current liabilities. Below are some transactions that often cause a change in the amount of working capital (WC):

Noncurrent (long-term) asset transactions:

  • Purchase of property, plant and equipment (causing WC to decrease)
  • Sale of property, plant and equipment (causing WC to increase)
  • Purchase of a long-term investment (causing WC to decrease)
  • Sale of long-term investment (causing WC to increase)

Noncurrent (long-term) liability transactions:

  • Proceeds from long-term loans (causing WC to increase)
  • Repayment of long-term loans (causing WC to decrease)

Stockholders' equity transactions:

  • Profits from its business operations (causing WC to increase)
  • Losses from its business operations(causing WC to decrease)
  • Proceeds from issuing capital stock (causing WC to increase)
  • Distribution of dividends (causing WC to decrease)
  • Repurchase of capital stock (causing WC to decrease)

Since working capital is defined as current assets minus current liabilities it will mean that:

  • If a company uses $1,000 of cash to pay $1,000 of its accounts payable, there is no change in the total amount of working capital. (Both the current assets and the current liabilities decreased by the same amount.)
  • If a company collects $2,000 of its receivables, there is no change in the total amount of working capital. (The current asset cash will increase by $2,000 and the current asset accounts receivable will decrease by $2,000.)

In other words, transactions which affect only the working capital accounts will not change the company's total amount of working capital.