Magazine article The RMA Journal

Negative Working Capital Is Not Negative-Heresy or Revelation? How the "Current Portion of Fixed Assets" Corrects the Miscalculation of Working Capital

Magazine article The RMA Journal

Negative Working Capital Is Not Negative-Heresy or Revelation? How the "Current Portion of Fixed Assets" Corrects the Miscalculation of Working Capital

Article excerpt

A CASH MANAGEMENT specialist structured a sophisticated package to reel in a major client from another bank. The package required a nominal $150,000 stand-by line of credit to cover daylight overdrafts. It would likely never be drawn. Nevertheless, the bank declined it because the company already had negative working capital of $1 million. Was this decision a correct one?

Our textbooks taught us that, in principle, negative working capital is a financial weakness, a sign of illiquidity. And yet AT&T and Walmart, with working capital of negative $5.3 billion and negative $2 billion, respectively, continue to pay their creditors and maintain top trade credit ratings.

Various explanations have been offered for the disconnect between principle and reality, but a recent discovery reveals that "negative working capital" is due to a flaw in how we calculate it.

Rethinking Working Capital: The Missing Piece

Working capital has many meanings. The Cash Flow Statement isolates a small, select group of operating accounts--accounts receivable, inventory, and accounts payable--in reporting the changes in working capital. This narrow focus is appropriate and practical; nevertheless, the textbook definitions of working capital and its variant, the current ratio, continue to hold sway in banks' spreadsheets, scoring models, and loan policy manuals, and therefore they do affect lending decisions--as in the opening story. Unfortunately, the textbook definitions understate liquidity, leading to loans that are inappropriately declined.

The formulaic textbook definition--"working capital = current assets - current liabilities"--can be restated as a more practical financial concept: Working capital is the portion of owners' capital that is invested in current assets. If we extend that logic, the owners' capital not invested in current assets must be invested in fixed assets--or fixed capital--with a similar formulaic definition: fixed capital = fixed assets - long-term liabilities. The conventional balance sheet already divides assets and liabilities into short term (current) and long term (fixed). Figure 1 applies the same logic to owners' capital, dividing it into the portion invested in current assets and the portion invested in fixed assets.

CPLTD and CPFA

Still, there is the meddlesome account called CPLTD, the "current portion of long-term debt," which, by name, includes both elements of "current" and "long term." CPLTD strips off a portion of long-term debt and moves it up into current liabilities on the correct logic that it is a debt due in the current period. The problem is that same logic was never applied to the left side of the balance sheet.

If we apply the same logic to the left side of the balance sheet, we would strip off the portion of fixed assets that will be used in the current period, giving rise to "the current portion of fixed assets," or CPFA. CPFA--the missing piece in liquidity calculations--was first revealed in the Journal of Accountancy in April 2012. (1)

The "current portion of fixed assets" is as much a part of current assets as the "current portion of long-term debt" is a part of current liabilities. The failure to recognize this explains the misreporting of working capital as negative. The graphic on the right side of Figure 2 illustrates that when CPFA is included among current assets, the negative working capital is eliminated.

An Illustration

Consider the simple case of Sam and Jim, who are movers. They pooled their cash for a down payment on a truck and found a bank willing to make them a five-year loan to finance the balance. Aside from a few dollars in their pockets for gas, they have only one fixed asset: the truck. And they have one loan: a long-term loan. But conventional accounting reports one year of principal payments as a current liability (CPLTD).

With no inventory and no accounts receivable, Sam and Jim have negative working capital. …

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