For most of us working in finance, the definition of working capital is familiar from the beginning of our careers; current assets less current liabilities. This tells us two, often conflicting things, firstly if the organisation liquidated all its short-term assets, could it pay its short-term debts? If so, it is usually seen as a sign of good credit and a strong balance sheet.
However, the other way to look at it, is that if the organisation has more current assets than current liabilities, then the company is clearly not very good at chasing up those who owe them money, but very willing to pay debts quickly, which could be a sign of bad liquidity management!
At the end of the day, this sort of analysis is only as good as the context you see it in, and usually the ugly truth will be found in the notes to the accounts.
Of course, things get much more complicated when looking at a local authority. At Arlingclose, every year we undertake balance sheet analysis for all our clients, as part of this we look at the council’s working capital position. Unlike with private sector analysis, we look at all the parts of the balance sheet which may temporarily be increasing the council’s cash, such as provisions, grants received in advance, and all the elements which may be decreasing it, such as large debtor positions.
Now, this may sound like a boring exercise! But it is important because many councils can’t explain their treasury position without understanding the working capital position. If a council has significantly lower investments than their reserves position would suggest, often it is the fault of a large debtor dragging the cash position down.
More important than understanding the present position, working capital can also hold the key to major treasury management planning and forecasting decisions. With budgets tight extracting every penny from the balance sheet makes a difference.
Imagine a council which has a large, unfunded capital programme which will spend £10m next year. If the same council has £20m of investments, then the treasury management decision is obvious, spend the cash and avoid external borrowing. But what if you investigated the position and found that the £20m was due to a working capital surplus, what should a prudent treasury manager do then?
The answer is of course: It depends. If the working capital surplus is temporary, then suddenly your projections have changed from a £10m investment position, to a £10m borrowing requirement. If however, the working capital position is mostly driven by a provision on the balance sheet that won’t need satisfying for at least five years, then we’re back to £10m, and no external borrowing.
It was easy to ignore this sort of analysis, even during times of austerity, but with the covid pandemic stretching budgets, and treasury functions being required to keep borrowing costs as low as possible (or even generate investment income) at the same time as cash balances are swinging wildly due to central government using councils as grant making bodies, working capital can no longer be the forgotten element of treasury planning.
In the above example, understanding the position correctly could save our imaginary council £250k per year in interest costs, by not borrowing when cash will be available. So before you exclude working capital form your analysis, ask yourself: can your council afford extra costs this year?
At Arlingclose, we undertake this detailed analysis for our clients every year, and our technical team is always available to discuss the detail of this outwardly dull, but extremely important, part of the treasury management puzzle so get in touch at firstname.lastname@example.org if you think we can help.