Key Points
- Working capital equals current assets minus current liabilities, and a negative figure signals potential liquidity pressure that auditors must evaluate under going concern procedures.
- The entity must present current and non-current assets and liabilities as separate classifications on the balance sheet.
- Misclassifying a liability as non-current when it is due within 12 months inflates working capital and can mask a breach of loan covenants.
- Auditors on mid-market engagements typically flag working capital deterioration exceeding 20% year-on-year as a going concern indicator worth investigating.
What is Working Capital?
IAS 1.66 defines a current asset as one the entity expects to realise or consume within its normal operating cycle or within 12 months after the reporting period. IAS 1.69 applies the mirror logic to liabilities: a liability is current when the entity expects to settle it within the normal operating cycle, holds it primarily for trading, the settlement date falls within 12 months, or the entity lacks an unconditional right to defer settlement for at least 12 months. Working capital is the arithmetic difference between these two pools.
The figure itself does not appear as a line item on an IFRS balance sheet, but it drives the going concern assessment that ISA 570.10 requires the auditor to perform. A deteriorating working capital position (particularly when combined with recurring operating losses or breached covenants) is exactly the kind of condition ISA 570.A3 identifies as potentially casting significant doubt on the entity's ability to continue as a going concern. The auditor's evaluation under ISA 570.16 considers whether management's plans to address negative working capital are feasible, and the events after the reporting period window can either confirm or contradict those plans.
Working capital also feeds ratio analysis during planning. The current ratio (current assets divided by current liabilities) and quick ratio restate the same information as a proportion rather than an absolute figure, which makes it comparable across entities of different sizes.
Worked example: Henriksen Shipping A/S
Client: Danish maritime logistics company, FY2025, revenue EUR 140M, IFRS reporter. Henriksen's balance sheet at 31 December 2025 shows the following current items:
| Current assets | EUR 000 | Current liabilities | EUR 000 |
|---|---|---|---|
| Trade receivables | 18,400 | Trade payables | 14,200 |
| Inventories (bunker fuel, spare parts) | 3,100 | Current portion of bank loans | 6,500 |
| Cash and equivalents | 4,800 | Accrued crew wages | 2,900 |
| Prepaid charter costs | 1,200 | Current tax liability | 1,400 |
| Total | 27,500 | Total | 25,000 |
Step 1 — Calculate working capital
EUR 27,500,000 minus EUR 25,000,000 produces working capital of EUR 2,500,000. The current ratio is 1.10.
Step 2 — Evaluate the year-on-year movement
Working capital declined by EUR 1,600,000 (39%) from the prior year. The decline is driven by a EUR 3,200,000 increase in the current portion of bank loans (a vessel financing facility that entered its final 12 months before maturity) partially offset by a EUR 1,800,000 increase in trade receivables from higher Q4 freight volumes.
Step 3 — Assess going concern implications
The 39% decline triggers ISA 570.A3's indicator of net current liability position approaching negative territory. Management's plan involves refinancing the vessel loan before the June 2026 maturity. The engagement team obtains the signed term sheet from the lender (dated February 2026) and evaluates whether the refinancing conditions are achievable.
Step 4 — Verify current/non-current classification
The engagement team tests whether all liabilities classified as non-current genuinely carry an unconditional right to defer settlement beyond 12 months per IAS 1.69(d). One trade finance facility of EUR 2,100,000 contains a covenant requiring a minimum current ratio of 1.15. Henriksen's actual ratio of 1.10 breaches this covenant at year-end. Unless the lender issues a waiver before the reporting date, IAS 1.74 requires reclassification to current, which would push working capital to EUR 400,000 and the current ratio to 1.01.
Conclusion: the working capital figure of EUR 2,500,000 (or EUR 400,000 after potential reclassification) is defensible only once the current/non-current classification is confirmed and the covenant waiver status is resolved; without that verification, the balance sheet presentation would be misleading.
Why it matters in practice
Teams frequently accept management's current/non-current split without testing covenant compliance at the reporting date. IAS 1.74-76 require reclassification of a liability to current when the entity breaches a covenant that gives the lender the right to demand immediate repayment, unless the lender agrees to waive the breach before the reporting date. Missing this reclassification overstates working capital and conceals liquidity risk from users of the financial statements.
The going concern link is often treated as a separate procedure disconnected from the working capital analysis. ISA 570.10 requires the auditor to consider whether events or conditions exist that cast significant doubt on going concern. A negative or rapidly declining working capital position is one of the most visible conditions, yet audit files sometimes contain a clean going concern conclusion alongside a working capital schedule showing a 40% year-on-year deterioration with no documented bridge between the two.
Working capital vs. free cash flow
| Dimension | Working capital | Free cash flow |
|---|---|---|
| What it measures | Short-term liquidity at a point in time (balance sheet snapshot) | Cash generated after capital expenditure over a period (flow measure) |
| Source | Statement of financial position: current assets minus current liabilities | Statement of cash flows: operating cash flow minus capital expenditure |
| Going concern relevance | Signals whether the entity can meet obligations falling due within 12 months | Signals whether the entity generates enough cash to sustain operations without additional financing |
| Manipulation risk | Reclassification of liabilities between current and non-current; deferral of payables past year-end | Capitalisation of operating costs to shift them from operating to investing cash flows |
| Audit focus | Verify current/non-current classification per IAS 1.69-76 and test covenant compliance | Verify operating cash flow per IAS 7.14 and test whether capital expenditure is correctly classified |
The two measures complement each other. An entity can report positive working capital while burning cash (because receivables are growing faster than collections), and an entity with negative working capital can be generating strong free cash flow (because it collects before it pays). Evaluating both prevents the auditor from drawing a one-dimensional liquidity conclusion.
Related terms
Frequently asked questions
How do I document a working capital analysis in the audit file?
Present a schedule of current assets and current liabilities at the reporting date, with comparative figures for the prior year. Calculate the absolute change and the percentage movement. ISA 315.A94 identifies liquidity ratios as part of the analytical procedures used to understand the entity. Record which drivers caused the movement and whether they indicate a recurring trend or a one-off reclassification.
Does a negative working capital position always mean going concern doubt?
Not automatically. Some industries operate with structurally negative working capital (large retailers collect cash from customers before paying suppliers). ISA 570.A3 lists net current liabilities as an indicator, not a conclusion. The auditor evaluates the indicator in context: if the entity has operated with negative working capital for years and has committed credit facilities backed by positive operating cash flow, the indicator alone does not create significant doubt.
When should I reclassify a non-current liability that affects working capital?
IAS 1.74 requires reclassification to current when the entity breaches a loan covenant at or before the reporting date and the lender has the contractual right to demand repayment, unless the lender formally agrees before the reporting date not to exercise that right. The 2024 amendment to IAS 1.72A further clarifies that covenants tested after the reporting date do not trigger reclassification at the reporting date itself.