Working capital

Uses of funds comprise all the operating costs incurred but not yet used or sold (i.e., inventories) and all sales that have not yet been paid for (trade receivables). Sources of funds comprise all charges incurred but not yet paid for (trade payables, social security and tax payables), as well as operating revenues from products that have not yet been delivered (advance payments on orders). The net balance of operating uses and sources of funds is called the working capital.

If uses of funds exceed sources of funds, the balance is positive and working capital needs to be financed. This is the most frequent case. If negative, it represents a source of funds generated by the operating cycle. This is a nice but rare situation! It is described as ‘‘working capital’’ because the figure reflects the cash required to cover financing shortfalls arising from day-to-day operations.

Sometimes working capital is defined as current assets less current liabilities. This definition corresponds to our working capital definitionþmarketable securities and net cash
short-term borrowings. We think that this is an improper definition of working capital as it mixes items from the operating cycle (inventories, receivables, payables) and items from the financing cycle (marketable securities, net cash and short-term bank and financial borrowings). You may also find in some documents expressions such as ‘‘working capital needs’’ or ‘‘requirements in working capital’’. They are synonyms for working capital.

Working capital can be divided between operating working capital and nonoperating working capital.

Only the normal amount of operating sources of funds is included in calculations of operating working capital. Unusually long payment periods granted by suppliers should not be included as a component of normal operating working capital. Where it is permanent, the abnormal portion should be treated as a source of cash, with the suppliers thus being considered as playing the role of the company’s banker.

Inventories of raw materials and goods for resale should be included only at their normal amount. Under no circumstances should an unusually large figure for inventories of raw materials and goods for resale be included in the calculation of operating working capital.

Nonoperating working capital

Although we have considered in sufficient detail the timing differences between inflows and outflows that arise during the operating cycle, we have until now always assumed that capital expenditures were paid for when purchased and that nonrecurring costs are paid for when they are recognised in the income statement. Naturally, there may be timing differences here, too, giving rise to what is known as nonoperating working capital.

Nonoperating working capital, which is not a very robust concept from a theoretical perspective, is hard to predict and to analyse, because it depends on individual transactions, unlike operating working capital which is recurring. In practice, nonoperating working capital is a catch-all category for items that cannot be classified anywhere else. It includes amounts due on fixed assets, dividends to be paid, extraordinary items, etc.

Capital employed

Capital employed is the sum of a company’s fixed assets and its working capital (i.e., operating and nonoperating working capital). It is, therefore, equal to the sum of the net amounts devoted by a business to both the operating and investing cycles. It is also known as operating assets.

Capital employed is financed by two main types of funds, shareholders’ equity and net debt, sometimes grouped together under the heading of invested capital.

The balance sheet shows a snapshot of cumulative inflows and outflows from the company classified into assets and resources (liabilities and shareholders’ equity). Assets comprise fixed assets (intangible and tangible fixed assets and long-term investments) and current assets (inventories, accounts receivable, marketable securities and cash and equivalents). Resources comprise shareholders’ equity and bank and financial borrowings, plus trade payables.

A capital-employed analysis of the balance sheet shows all the uses of funds by a company as part of the operating cycle and analyses the origin of the sources of a company’s funds at a given point in time. On the asset side, the capital-employed balance sheet has the following main headings:

• fixed assets; i.e., investments made by the company;
• operating working capital (inventories and trade receivables under deduction of trade payables). The size of the operating working capital depends on the operating cycle and the accounting methods used to determine earnings;
• nonoperating working capital, a catch-all category for the rest.

The sum of fixed assets and working capital is called capital employed. Capital employed is financed by capital invested; i.e., shareholders’ equity and net debt. Net debt is defined as bank and financial borrowings, be they short, medium or long term, less marketable securities (short-term investments) and cash and equivalents. A solvency-and-liquidity analysis lists everything the company owns and everything that it owes, the balance being the book value of shareholders’ equity or net asset value. It can be analysed from either a solvency or liquidity perspective.

Solvency measures the company’s ability to honour its commitments in the event of liquidation, whereas liquidity measures its ability to meet its commitments up to a certain date by monetising assets in the ordinary course of business.