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Advanced Working Capital Analysis Advanced working capital analysis is not a technique that you are apt to use very often, but it can prove invaluable in cases where credit risk is unusually high, or the amount of credit requested is very large.
Working capital is the excess of current assets over current liabilities. When similar amounts are added to or subtracted from both current assets and current liabilities [such as occurs with the purchase of inventory on open-account terms] does not change the amount of working capital, although the activity does change the working capital ratio. The purpose of working capital analysis is to identify the factors that cause changes in the actual amount of a firm's working capital, and these factors are always to be found below the "current" line on either side of the balance sheet. Moreover, they can always be listed in one of three basic categories:
Changes in Net Worth The major changes affecting working capital usually involve changes in net worth. If working capital increases, the most common source is an increase in net worth- especially an increase resulting from profitable operations. If working capital declines, the most common and most worrisome cause is a decline in net worth resulting from operating losses. In the case of the Denault Company, net worth increased by $45,000 one year. The source of this increase, and consequently the source of an increase in working capital, was a profit of $80,000. Offsetting this increase was an application of funds in the form of dividends paid, which reduced working capital by $35,000.
On occasion, a credit analyst will also find changes in the amount of a firm's working capital caused by net worth changes that are the result of factors other than operational profits or losses. Working capital may increase, for example, because of refunds on prior years' taxes, profits from the sale of fixed assets, or other profits which do not appear on the income statement (such as profits of a non-recurring nature or those earned from operations in previous years). Working capital may be reduced by certain additional debits to surplus, such as assessments on prior years' taxes.
Changes in Long-Term Debt When performing working capital analysis, it is important to guard against the assumption that anything that increases working capital is good. The creation or increase of long-term debt is a source of funds for working capital, but may not be as desirable as equity investments. There are several reasons for this:
The Denault Company reduced its long-term debt by $10,000 in one year, a change that educed its working capital by a like amount. Notice that no actual payment was made to reduce the debt. Instead, the $10,000 current maturity was included under current liabilities. This had the effect of reducing working capital since it resulted in an increase in current liabilities - without a corresponding increase in current assets.
Changes in Noncurrent Assets Working capital is reduced by any increase in noncurrent assets, particularly in fixed assets. If a credit professional learns that a prospective credit customer is enlarging or modernizing plant facilities, he or she should find out if the undertaking is adequately financed. If there is enough working capital, the out of pocket costs may come out of these funds and there will still be enough left over to pay other current liabilities. Otherwise, the expansion will have to be financed either by obtaining additional equity capital or by negotiating a long-term loan. A reduction in fixed assets, which results in an increase in working capital, is usually the result of depreciation charges made during the year. Occasionally, an analyst may find the working capital has been increased by the sale of fixed assets, but normally this is not a major source of cash. Other important changes to look for include:
The Denault Company's noncurrent assets were reduced by $30,000 in one year and its working capital increased accordingly. The decrease resulted from a $20,000 reduction in fixed assets (principally the result of depreciation charges having exceeded plant expenditures) and from the $10,000 reduction in prepaid and deferred assets. These were the factors responsible for the Denault Company's $65,000 working capital increase. They are summarized below in a working capital reconciliation. Notice that all of the sources of funds that contributed to the increase are totaled first. Next, all of the applications of funds that reduce working capital are deducted from that total.
Analysis of Working Capital Composition Understanding factors that have caused changes in the amount of a firm's working capital from one period to another in no way diminishes the need to know the changes that have occurred in working capital composition. The adequacy of any company's working capital depends on the proportion of current assets to current liabilities-not on the dollar amount of working capital.
To discover changes in composition, credit analysts must shift their attention above the Current line of the balance sheet and try to answer such questions as the following:
In the case of the Denault Company, although the amount of working capital increased by $65,000, the working capital ratio has dropped from 10.0 ($400,000 ÷ $40,000) to 5.25 ($525,000 ÷ $100,000). Investment in current assets increased by $125,000: $50,000 in receivables and $75,000 in inventories.
However this was offset by an increase of $60,000 in current liabilities-primarily by the $50,000 notes payable to the bank. In summary form these working capital changes look like the following:
An analysis of composition and sources and applications of the working capital shows that working capital requirements of the firm rose considerably during the year and that they were financed partly by increases in working capital and partly by short-term loans from the bank.
In view of these facts, it would be a good idea to monitor the Denault Company's relationship with its bank carefully. |
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