The Accounting Concept of Working Capital: A Critique

Introduction

We concluded Chapter Two by observing that the key to understanding efficient working capital management requires an appreciation of how a company's terms of sale can increase the demand for its products and services to produce maximum profit at minimum cost. Before developing this theme throughout the remainder of the text, the purpose of this Chapter is to reveal in greater detail why:

The traditional accounting definition and presentation of working capital in published financial statements and its conventional interpretation by external users of accounts reveals little about a company's "true" financial position, or managerial policy.

If proof were needed, I suspect one of the first things that you learnt from your accounting studies and rehearsed in the answer to the first part of the previous Chapter's Review Activity is that using Balance Sheet analysis:

The conventional concept of working capital is defined as an excess of current assets over current liabilities revealed by financial reports. It represents the net investment from longer-term fund sources (debt, equity or reserves) required to finance the day to day operations of a company.

This definition is based on the traditional accounting notions of financial prudence and conservatism. Because current liabilities must be repaid in the near future, they should not be applied to long term investment. So, they are assumed to finance current assets.

Yet we all know that in reality (rightly or wrongly) new issues of equity or loan stock and retentions are often used by management to finance working capital. Likewise, current liabilities, notably permanent overdraft facilities and additional bank borrowing may support fixed asset formation.

None of this is revealed by an annual Balance Sheet, which is merely a static description and classification of the acquisition and disposition of long and short term funds at one point in time, prepared for stewardship and fiscal purposes, based on generally accepted accounting principles (GAPP).

Not only do Balance Sheets fail to identify the dynamic application of long and short-term finance to fixed and current asset investment. But because they are a cost-based record of current financial position, they provide no external indication of a firm's value or future plans (which are the bedrock of internal financial management).

The Accounting Notion of Solvency

For the external user of published accounts interested in assessing a company's working capital position and credit worthiness, you should also have noted in your answer to the first part of Chapter Two's Review Activity that:

Within the context of traditional financial statement analysis, without access to better information (insider or otherwise) any initial interpretation of a firm's ability to pay its way is determined by the relationship between its current assets and current liabilities.

Analytically, this takes the form of the working capital (current asset) ratio, with which you should be familiar.

Convention dictates that the higher the current ratio, the easier it should be for a company to meet its short term financial obligations (I.e. pay off its current liabilities) which are more susceptible to fluctuation test

Positive working capital is conventionally interpreted as an indicator of financial strength. The ratio should be consistent within the company over time, yet stand up against competitors or the industry average at any point in time. There is also a textbook consensus (with which you should be familiar) that an upper 2:1 ratio limit is regarded as financially sound. Otherwise, current asset investment may be wasteful (although if business conditions improve or deteriorate, companies may periodically depart from convention).

Zero working capital defines a company's minimum working capital position, calibrated by a 1:1 ratio of current assets to current liabilities.

Moving on to the second part of Chapter Two's Review Activity:

From a traditional accounting perspective, a 1:1 ratio of current assets to current liabilities (zero working capital) defines corporate solvency. This arithmetic minimum is justified by a fundamental corporate objective, namely survival.

To survive, a firm must remain solvent. Solvency is a question of fact, since it is maintained as long as current financial obligations can be met. Insolvency arises when debts due for payment cannot be discharged.

Referring back to Chapter Two (Figure 2.2) you will recall that current assets are continuously transformed into cash as operating cycles run their course, whilst current liabilities represent imminent capital repayments that are assumed to fall due within one year. So, taking either year as the current period, the working capital (current) ratio is assumed to reflect solvency (or otherwise) at Sound Garden's annual Balance Sheet publication date.

The corresponding figures in Activity 1 show an ability to meet current liabilities out of current assets, however they are compared. The theoretical minimum limit to solvency is a current ratio of 1:1, or net working capital of zero (defined as an excess of current assets to current liabilities).

Assuming the overdraft facility is used to finance increased working capital commitments, (stocks, debtors and precautionary cash balances), the current ratios for each year are:

So which ratio is preferable?

Conventional accounting analysis dictates that the higher the current ratio, the better Sound Garden plc can meet its impending financial obligations. As we mentioned earlier, the ratio should also be consistent within the company over time, yet stand up against competitors or the industry average at any point in time. There is a textbook consensus that a 2:1 ratio is financially sound, although if business conditions improve or deteriorate, companies may periodically depart from convention.

Thus, without more detailed information, we might conclude that the current ratio for Year 1 is unduly cautious, whilst that for Year 2 indicates possible bankruptcy if trends continue.

But all is still not revealed