Our study of working capital began by regarding an excess of current assets over current liabilities as highly desirable. Convention dictates that it measures the extent to which a company can finance any future increase in turnover. If the balance is zero, it may be a sign of trouble. The firm is assumed to possess no working capital, since the net cash inflows from future operating cycles must be committed to the payment of existing financial obligations. However, it is also important to realize that any "surplus" may be misleading, since it could relate to assets already committed to a firm's existing operating cycles.
As a consequence, only if a firm were to cease trading altogether would accounting notions of solvency and liquidity (based upon a static ex post Balance Sheet analysis) give any indication of its "true" creditworthiness. As a going concern, it is the firm's ability to exploit its future trading position that determines an adequacy of cash resources to meet debts as they fall due.
As we shall discover, debt-paying ability is a dynamic concept, which should not depend upon external user attitudes (notably creditors) towards statements of current financial position, but rather the firm's future operating efficiency. This may be defined as the inter-relationship between:
- Future profitability
- The operating cycle (the conversion period of assets to cash),
- The financing cycle (the repayment period granted by creditors).
To illustrate why the internal dynamics of efficient working capital management can be at variance with its external interpretation, imagine that you initially commenced business on July 1st last year without any start-up capital.
Your intention was to exploit a gap in the market by importing specialist music CD boxed sets to the UK mainland from the UK Channel Islands, in order to avoid tax (which is quite legal).
At the beginning of each month, you acquired inventory of £5000 on three months credit. At the end of each month it was sold for cash. Your profit margin was 50 per cent on cost. Cash inflows from sales were not withdrawn. They were utilized to finance fixed asset investment (the purchase of business premises) at the beginning of each following month, compatible with your debt paying ability, to expand the subsequent year's operations.
You are required to produce beginning and end of month Balance Sheets, calculate their corresponding profitability, working capital, stock and creditor ratios for the first twelve months and interpret the results.
For the purpose of exposition, I have kept the example deliberately simple. The data relates to a trading and not a manufacturing company, which we shall consider in Chapter Five. So, there are no raw materials, or work in progress, to complicate our analysis. The absence of any start up capital (ownership or debt) also enables us to focus on the flexibility of working capital investment. Specifically, how creditor finance or cash surpluses can be diverted to fixed asset formation, without compromising a firms "real" solvency or liquidity positions.
Beginning and end of month Balance Sheets for the first quarter are reproduced in Table 4.2, assuming that the "terms of trade" offered to customers and received from suppliers remain constant throughout the twelve month period and none of the sequential fixed asset investments have been sold. I have left you to calculate the Balance Sheets for the remainder of the year to confirm the figures that I have also provided for July 1st twelve months later. Table 4.3 then provides a summary of the requisite financial ratios derived from Table 4.2 as a basis for interpretation.
(b) The Balance Sheets
Table 4.2: Statements of Financial Position
(c) The Ratios
Now we can reformulate Table 4.2 using a selection of financial ratios within a coherent framework as a basis for interpretation.
- Profitability in terms of return on assets (ROCE), net profit margins and asset utilization,
- Working capital, using current asset and liquidity ratios,
- The operating cycle (stock turnover),
- The financing cycle (creditor turnover).
Table 4.3: The Financial Ratios
(d) The Interpretation
The first point to note is that although the ratios correspond to those calculated by external users of published financial statements, the firm's creditors (the only external user group, apart from the tax authorities) would not have access to all this the information. Even in the corporate sector, at best they may have an interim report. Alternatively, they will only have access to a Balance Sheet on the date it is drawn up ("struck") at the year's end as a basis for interpretation (say July 1st in our example).
Secondly, without access to further managerial (insider) information that the terms of trade remained the same throughout the period:
- Inventory was acquired on three months credit and sold for cash at the end of each month.
- Cash from sales was not withdrawn but utilized to finance fixed asset investment at the beginning of the following month.
All the published year end ratios highlight are a confusing report of high profitability underpinned by a working capital deficiency.
So, how do we reconcile this conventional interpretation of your firm's ex post performance with its internal business dynamics, even if we assume that prices remained constant throughout the period?
(d) The Interpretation
The Review information provided in Table 4.3 reveals that whilst monthly turnover and profit margin remains the same, the sales to asset ratio and hence the overall rate of return (ROCE) fluctuates during the first quarter, thereafter rising to the year-end. Yet, your firm has adopted a policy of consistently maximising its reinvestment potential, rather than allowing cash to lie idle, or repay creditors prior to their due date.
Obviously, using the funds of others at no explicit cost for your benefit (in order to set up the business and subsequently finance its future operation) is extremely efficient. Unfortunately, it has a depressing effect on "reported" profitability when reinvestment is higher (August and September), but a beneficial effect thereafter.
There is also the question of whether a higher rate of return on lower capital employed is preferable to a lower return on higher capital, or vice versa. In absolute terms, your business is definitely more profitable by September 1st than the previous July 31st. But with the exception of the profit margin, all that conventional financial ratio analysis reveals is a significant deterioration in efficiency.
(ii) Working Capital
The decline in working capital is a corollary to the build up of creditors and the transformation of cash into fixed assets. In August, working capital is negative and for the most part liquidity is non-existent. By July of the following year, both the current and liquidity ratios are still highly unfavorable at 1:3 respectively. But you are neither insolvent, nor illiquid, unless you were to cease trading altogether.
(iii) The Net Working Capital Cycle
Given the terms of trade, you are well able to meet your financial obligations when they first fall due in October. Moreover, you can still continue to invest £2,500 elsewhere. Reversing conventional logic, it is no accident that the relationship between the operating and financing cycles, first revealed on October 1st is also 1:3. Inventory is being profitably converted to cash three times quicker than debts are being legitimately paid. All other things being equal, only if credit had been granted to customers, perhaps accompanied by bad debt loss (thereby, increasing the operating cycle) or suppliers demanded earlier repayment (reducing the financing cycle) would you have experienced a cash shortage, leading to possible insolvency. Yet, ironically, all the Balance Sheet analysis would reveal is an increase in current assets, a reduction in current liabilities perhaps culminating in a "positive" net working capital position!
Summary and Conclusions
This Chapter's Review Activity vividly illustrates what we have mentioned earlier. How a conventional interpretation of working capital data contained in published financial statements may not only mislead external users of accounts but also contrast sharply with the overall wealth maximising objective of internal financial management, namely:
To maximise the demand for a firm's products and services through optimum, profitable investments, financed at minimum cost, all determined by its terms of sale.
To prove the case, we have confirmed why the accounting concept of working capital (which defines an excess of current assets over current liabilities as an indication of financial strength) and its interpretation (often benchmarked by a 2:1 current asset ratio) may be suboptimal and way of target.
As we shall discover in future Chapters (in line with the only logical conclusion from our previous Review Activity):
The normative objective of efficient working capital management should be to minimise current assets and maximise current liabilities, subject to the constraint of maintaining a sound liquidity position, which also maximises opportunities for fixed asset investment.