CHAPTER 8WORKING

CAPITAL

Working Capital Net short-term investment needed to carry on

day-to-day activities Computed

Current Assets Current Liabilities

Minus

Working Capital Issues

1. Inconsistencies in the measurements of its components

2. Differences of opinion over what should be included as the elements

3. Lack of precision in defining the elements particularly with respect to the terms “liquidity” and

“current”

Purpose of the Chapter

1 Examine the foundation of the working capital concept

2 Review the concept and its components as currently understood

3 Illustrate how the adequacy of a company’s working capital can be evaluated

4 Discuss possible modifications

Development of the Working Capital Concept

Fixed vs. circulating capital The double-account system Creditor vs. investor point of view Liquidity as the basis for asset

classification on the balance sheet Will be vs. could be Anson Herrick and ARB No. 3 - the operating cycle Current usage - indication of liquidity and degree of

protection to short-term creditors

Components of Working Capital

ARB No. 43 Definition of working capital Examples of current assets and

current liabilities

Current Assets

Cash Cash equivalents

Cash

CashEquivalents

Current Assets Temporary investments Alternative methods

Historical cost Fair value Lower of cost or market

Temporary Investments

SFAS No. 12 Why adopted

Problems with SFAS No. 12

Temporary investments under SFAS No. 115 Trading securities Available-for-sale securities Held-to- maturity securities Transfer between categories

Current Assets Receivables

Bad debts SFAS No. 114

InventoriesReceivablesPrepaids

Inventories Inventory quantity Flow assumption Market fluctuations

Prepaids

Current Liabilities

Payables DeferralsPayables

CurrentMaturities

Financial Analysis of a Company’s Working Capital Position

How do liquidity problems occur?

Evaluate with ratio analysis

Working Capital

Current Assets Current Liabilities

Problems with its use

Current Ratio

Current assets

Current liabilities

Acid Test (Quick) Ratio

Cash + Marketable Securities + Receivables

Current liabilities

Cash Flow from Operations to Current Liabilities

Net cash provided from operating activities

Average current liabilities

Receivables

Accounts receivable turnover ratio

Days in receivables

Net Credit Sales

Average Accounts Receivable

365

Accounts Receivable Turnover Ratio

Inventory

Inventory turnover ratio

Average days in inventory

Cost of Goods Sold

Average Inventory

365

Inventory Turnover Ratio

Accounts Payable

Accounts payable turnover ratio

Average days payables outstanding

Inventory Purchases

Average Accounts Payable

365

Accounts Payable Turnover Ratio

Summary of Hershey’s Working Capital Position

1. Customers pay accounts receivable in approximately 37 days.

2. Inventory remains on hand for approximately 79 days.

3. Current operations are generating sufficient cash to repay current liabilities.

4. Accounts payable are being satisfied in approximately 19 days.

1. Accounts receivable are paid in approximately 22 days.

2. Inventory remains on hand for approximately 69 days.

3. Current operations are generating sufficient cash to repay current liabilities.

4. Accounts payable are being satisfied in approximately 23 days.

Summary of Tootsie’s Working Capital Position

InternationalAccounting Standards

The IASC has issued pronouncements on the following issues affecting working capital:1 Revised IAS No. 1, “Presentation of

Financial Statements” presentation of current assets and current

liabilities2 IAS No. 25, “Accounting for Investments”

accounting for and disclosure of investment securities in

3 IAS No. 2 , “Inventories”

IAS No. 1

The IASC did not attempt to deal with the valuation issues discussed earlier in the chapter

Discussed two views of current assets and current liabilities:1 A measure of liquidity2 Identification of circulating resources and obligations

Since these views are contradictory, it has lead to classifications of items by convention

Allows, but does not require, companies to decide whether or not to sub-classify assets and liabilities as current

FASB staff review indicated that it was quite similar to U. S. GAAP

IAS No. 25

Allows investments classified as current to be accounted for by market value or LCM

Value may be determined individually, by investment category, or on a total portfolio basis

Preference for the total portfolio or investment category methods

No review by FASB staff because topic was under reconsideration by both FASB and IASC at the time of the review

IAS No. 2

Objective of inventory reporting is to determine proper amount of cost to recognize as an asset

Specific identification method preferred If not feasible, FIFO or weighted average preferred LIFO is an allowable alternative If LIFO is used, must disclose lower of cost

and net realizable value FASB staff indicated that requirements were

similar to U.S. GAAP wide range of alternatives and lack of adequate

disclosure requirements in both make intercompany comparisons virtually impossible

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Prepared by Richard Schroeder, PhDKathryn Yarbrough, MBA