Working Capital Management and Fixed Asset Depreciation
Depreciation of Fixed Assets
Annual Depreciation of Fixed Assets
It reflects the annual depreciation for fixed assets, accounting for their reduction in value due to use in the production process. This is recorded as an Expenditure.
Accumulated Depreciation of Fixed Assets
This collects the accumulated depreciation made annually for all elements of fixed assets (or non-current assets) suffering depreciation since their acquisition. It functions as a contra-asset account, meaning it is active but carries a negative sign, reducing the book value of the assets.
Understanding Working Capital (WC)
Definition and Purpose of Working Capital
Working Capital (WC) is defined as the portion of current assets (short-term investments) that are funded from equity and non-current liabilities (long-term funding). It represents the set of resources the company needs to fund itself during the operating cycle—specifically, the period between the time the company pays suppliers and the time customer claims are collected.
Therefore, the shorter this operating cycle period is, the lower the working capital needed.
Analytical Calculation of Working Capital
Working Capital can be calculated in two primary ways:
1. Based on Liquidity (Balance Sheet Structure)
Working Capital is the difference between Current Assets (AC) and Current Liabilities (PC):
WC = AC – PC
2. Based on Funding (Permanent Resources)
Working Capital can also be understood as the difference between permanent resources (Equity and Non-Current Liabilities) and Non-Current Assets (ANC). This highlights the portion of permanent resources used to finance current assets:
WC = (PN + PNC) – ANC
Where:
- PN: Equity (Patrimonio Neto)
- PNC: Non-Current Liabilities
- ANC: Non-Current Assets
The Double Meaning of Working Capital
Working Capital serves two critical functions:
- It is the current assets necessary to sustain the pace of business activity.
- It is the amount of permanent resources (equity and non-current liabilities) that companies allocate to achieve stability in their operating activities.
Logically, Working Capital can be positive, negative, or zero, and this status may be specific to each company or business sector.
Working Capital and Financial Stability
A positive working capital (AC > PC) provides a positive operating margin for the company, as its current assets are sufficient to liquidate all its required short-term obligations (current liabilities) while still maintaining a financial buffer.
A balanced situation is achieved when the resources used to finance the working capital portion of current assets are permanent resources (such as equity, long-term loans, or long-term borrowing obligations), meaning they do not present short-term demandability. In contrast, other current asset investments are short-term, meaning their yields are also short-term and are financed with resources from current liabilities.
Basic Conditions for Financial Balance
To ensure a balance in the relationship between assets and liabilities, the following basic conditions must be met:
- The permanent and long-term financial resources (equity and non-current liabilities) should finance long-term investments (non-current assets) and a portion of current assets (working capital).
- Short-term financial resources (current liabilities) must finance the remaining part of short-term investments (the remaining part of current assets).
Implications of Negative Working Capital (WC < 0)
Working Capital should be sufficient to ensure the short-term operation of the company and guarantee the stability of the financial structure.
A negative working capital (WC < 0) means that Current Assets are less than Current Liabilities (AC < PC). This implies that part of the long-term investments (non-current assets) is being financed by short-term debt, which is required in the short term.
This mismatch causes severe liquidity problems, as the company may struggle to pay its short-term debts and could face insolvency.
In a balance sheet structure with negative working capital, current liabilities are funding assets that are not running the company’s operations effectively. This is often visually represented by shading the non-current assets financed by current liabilities.
Formula for Negative Working Capital
WC = AC – PC < 0