Solvency and Working Capital

Working capital describes liquidity. No liquidity means eventually running out of cash. This shows how working capital is calculated in the balance sheet.

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.

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