Equity and Liquidity
A balance sheet forecast showing positive net assets / equity does not describe whether or not a business posseses the means to meet all of its liabilities as they fall due for payment.
That calls for positive working capital, which is described by net current assets, calculated as follows:
| Cash in the Bank and in Hand |
| plus: Cash Convertibles (within 1 year) e.g. Current Assets: Stock; Debtors; Prepayments |
| less: Current Liabilities (payable within 1 Year) e.g. Creditors; Asset Finance; the Overdraft |
| equals: Net current Assets / Working Capital |
Note that fixed assets of any description have no role whatsoever when calculating net current assets. Because they are never acquired for the purpose of resale they are always considered to be "illiquid" assets.
Working Capital and Cash Flow
Net current assets / working capital also represent liquidity; the measure of the ability of a business to pay its bills on time.
The role of working capital is generate cash as and when it's needed. If working capital is in deficit though the liklihood is that it will be unable to generate that cash flow, leading to the very real prospect of cash flow insolvency.
An example of this comes from net curent assets / working capital in the 2017 balance sheet of a well known restaurant chain, which was subsequently forced into a CVA.
The result of that was suppliers having to agree to accepting substantial losses on cash that was owed to them.
| Cash in the Bank and in Hand | £6,535,631 |
| Stocks | £9,696,196 |
| Debtors | £2,645,628 |
| Total Current Assets | £18,722,730 |
| less: Current Liabilities | -£23,971588 |
| Net Curent Assets (Working Capital) | -£5,248,858 |
Their balance sheet showed equity / total net assets of £14 million, supported by £55Million of fixed assets. £43 million pf those however were "leasehold improvements" which had a true cash value of zero because at the end of the lease those improvements revert to the landlords.
The true value of this business was better described by its £5 million working capital deficit herefore than by its equity - i.e. worthless.
Low Working Capital Ratio
Another issue; only slightly less dangerous to potential creditors than the above is if the working capital of a business is positive but very low in relation to its current liabilities.
In such an example the ability of a business to raise loans becomes questionable. To illustrate that the following balance sheet figures are shown from an actual company return filed in recent years:
| Cash in the Bank and In hand | £725,582 |
| Stock / Inventory | £82,625 |
| Debtors | £208,629 |
| Total Current Assets | £1,016,836 |
| less: Current Liabilities (payable within 12 months) | £1,015,123 |
| Net Current Assets (Working Capital) | £1,713 |
Don't be Beguiled by Cash
Note that in both of these examples their current assets included substantial amouints of cash in hand.
In the case of the restaurant chain their millions in cash was already "spoken for" though, leaving an outstanding balance of debt of £17,435,957 with only £12,187,099 of cash convertible assets to pay it.
The risk with the second company is that with cash and cash convertibles at just 0.17% greater than their outstanding current liabilities, the act of purchasing a new computer or a new carpet for the boardroom could arguably render the business cash flow insolvent.
Depleting Working Capital
Trading losses are not the only route to negative working capital deficit. Spending cash and creating new debt are inevitable bedfellows when investing in fixed assets. If that turns out to have been excessive though, negative working capital will be the result regardless of profits.
Forecasting Working Capital
Avoiding such problems calls for planning and that in turn relies on accurate and comprehensive forecasting.
This is what Figurewizard enables you to do, usually in less than ten minutes, and that includes calculating and applying all possible VAT and corporation tax liabilities without any intervention on your part.
I still cant get my head round a business having 750,000 in the bank having a problem. Surely if I sell goods to them on credit they must be able to pay with that sort of money in the bank?
Forget the £750,000 in cash and concentrate on the £1,713 of working capital and the "current liabilities". In the example above those liabilities amount to £1,016,256 so that if they were to use all of their cash to pay creditors, they would still be left with a balance of current liabilities totalling £266,256 that also must be paid. To pay those will need collecting every penny from "sundry debtors" in short order (e.g. less than thirty days) with no delays; no disputes and no bad debts.
If they were able to do this; which in the real world is highly unlikely, selling goods on credit to them with a working capital ratio of 0.17% to liabilities can only mean that your position in their pecking order would be worth £1,713 at its very unlikely best. Even then that £1,713 would depend on them not having spent any more cash or having incurred any more debts in the meantime.
I have run forecasts and my balance sheet is showing net current assets of £20575. Is this my true liquidity or is it the short term liquidity and if so what is the difference?
@GGCook Because current assets are those which are considered to be genuinely cash convertible within twelve months, net current assets (AKA working capital) is the generally accepted definition of liquidity. Short term liquidity, which is assessed without stock / inventory means what it says however and should be referred to in order to establish how much external financing or loans are required to meet temporary shortfalls in budgeted cash flow.
What is the situation with fixed assets that are financed by hire purchase? Would the cash due for repayments be treated as current liabilities too or would they be exempt? I ask this because I am being told by my accountant that with rules coming into force in 2019 it might be better to buy assets outright, financed by hire purchase rather than to lease them.
Current liabilities represent all liabilities payable within twelve months. The fact that that the debt is attached to a fixed asset does not alter the fact that it is cash that is expected to be taken out of the business.
Your point regarding changes from 2019 regarding leases is an important one. This arises from a new accounting protocol; IFRS 16 that will affect all balance sheets and perceived liquidity. Click here for more on this.