CHAPTER 8 WORKING CAPITAL 1

Working Capital Minus Current Assets Current Liabilities Net short-term investment needed to carry on day-to-day activities Computed Minus Current Assets Current Liabilities 2

Working Capital Issues Inconsistencies in the measurements of its components Differences of opinion over what should be included as the elements Lack of precision in defining the elements particularly with respect to the terms “liquidity” and “current” 2

Purpose of the Chapter Examine the foundation of the working capital concept Review the concept and its components as currently understood Illustrate how the adequacy of a company’s working capital can be evaluated Discuss possible modifications 3

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 4

Components of Working Capital ARB No. 43 Definition of working capital Examples of current assets and current liabilities 6

Current Assets Cash Cash equivalents Cash Equivalents Cash 5

Temporary Investments Current Assets Temporary investments Alternative methods Historical cost Fair value Lower of cost or market 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 Temporary Investments 7

Current Assets Receivables Inventories Prepaids Prepaids Bad debts SFAS No. 114 Inventories Inventory quantity Flow assumption Market fluctuations Prepaids Prepaids Inventories Receivables 8

Current Liabilities Current Maturities Payables Deferrals Payables 9

Financial Analysis of a Company’s Working Capital Position How do liquidity problems occur? Evaluate with ratio analysis

Working Capital Problems with its use 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 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 Customers pay accounts receivable in approximately 37 days. Inventory remains on hand for approximately 79 days. Current operations are generating sufficient cash to repay current liabilities. Accounts payable are being satisfied in approximately 19 days.

Summary of Tootsie’s Working Capital Position Accounts receivable are paid in approximately 22 days. Inventory remains on hand for approximately 69 days. Current operations are generating sufficient cash to repay current liabilities. Accounts payable are being satisfied in approximately 23 days.

International Accounting Standards The IASC has issued pronouncements on the following issues affecting working capital: Revised IAS No. 1, “Presentation of Financial Statements” presentation of current assets and current liabilities IAS No. 25, “Accounting for Investments” accounting for and disclosure of investment securities in 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: A measure of liquidity 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

Prepared by Richard Schroeder, PhD Kathryn Yarbrough, MBA End of Chapter 8 Prepared by Richard Schroeder, PhD Kathryn Yarbrough, MBA Copyright © 2009 John Wiley & Sons, Inc.  All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful.  Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc.  The purchaser may make back-up copies for his/her own use only and not for distribution or resale.  The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.