FINANCIAL ACCOUNTING

THEORY AND ANALYSIS:

TEXT AND CASES
11TH EDITION

RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
CHAPTER 8
WORKING
CAPITAL
 Working Capital
 Net short-term investment needed to carry on
day-to-day activities
 Computed

Minus

Current Assets Current Liabilities

 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
 Affirmed in No. 115 (FASB ASC 330)
 Current Assets
 Cash
 Cash equivalents
 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 (FASB ASC 320)
 Trading securities
 Available-for-sale securities
 Held-to- maturity securities
 Transfer between categories
Current Assets
 Receivables
 Categories
 Trade
 Nontrade

 Bad debts
 SFAS No. 114
 Inventories
 Inventory quantity
 Flow assumption
 Market fluctuations
 Prepaids
Current Liabilities
Payables
Deferrals
Current maturities of long-term debt
Current
Maturities

Payables
 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

Working Capital
Hershey
Current Current Working
Assets Liabilities Capital
2011 $2,046,558 - $1,173,775 = $872,783
2010 $2,005,217 - 1,298,845 = 706,372

Tootsie Roll
Current Current Working
Assets Liabilities Capital
2011 $212,201 - 58,355 = $153,846
2010 $235,167 - 58,505 = $176,662

Working Capital for both companies’ has worsened, although Tootsie Roll is in
a better position in both years, with respect to this metric alone.
Current Ratio

Current assets

Current liabilities
Current Ratio
Hershey
$2,046,558
2011 $1,173,775 = 1.74:1

$2,005,217
2010 = 1.54:1
$1,298,845

Tootsie Roll
$212,201
2011 $ 58,355 = 3.64:1

$235,167
2010 = 4.02:1
$ 58,505

The current ratio for both companies is worsening.

Tootsie Roll’s current ratio is better than Hershey’s for both years.
Acid Test (Quick) Ratio

Cash + Marketable Securities + Receivables

Current liabilities
Acid Test (Quick) Ratio
Hershey
$693,686 + 399,499
2011 $1,173,775 = 0.93:1

$884,642 + 390,061
2010 = 0.98:1
$1,298,845

Tootsie Roll
$78,612 + 41,895 + 10,895
2011 $58,355 = 2.25:1

$115,976 + 37,394 + 7,996

2010 = 2.76:1
$58,505

Quick ratio is worsening for both companies.

Tootsie Roll’s quick ratio is significantly better than Hershey’s for both
years.
Cash Flow from Operations to
Current Liabilities

Net cash provided from operating activities

Average current liabilities

Cash Flow from Operations to Current
Liabilities
Hershey
$580,867
2011 ($1,173,775 + 1,298,845) /2 = 0.47:1

$901,423
2010 = 0.82:1
($1,298,845+ 910,628) /2

Tootsie Roll
$50,390
2011 ($58,355 + 58,505) /2 = 0.86:1

$825,805
2010 = 1.45:1
($58,505 + 910,628) /2

This metric is deteriorating for both companies.

 Receivables

 Accounts receivable turnover ratio

Net Credit Sales

Average Accounts Receivable

 Days in receivables

365

Accounts Receivable Turnover Ratio

Accounts Receivable Turnover Ratio

Hershey
$6,080,788
2011 ($399,499 + 15,000 + 390,061,+ 15,200) /2 = 14.84

$5,671,009
2010 = 13.64
($390,061 + 15,200 + 410,390 + 15,700) /2

Tootsie Roll
$528,369
2011 ($41,895 + 1,731 + 37,394 + 1,531) /2 = 12.80

$492,742
2010 = 13.13
($37,394 + 1,531 + 37,512 + 2,356) /2

This metric is improving for both Hershey but worsening for Tootsie Roll.
Days in Receivables Ratio
Hershey
365
2011 14.84 = 24.60

365
2010 = 26.75
13.64

Tootsie Roll
365
2011 12.80 = 28.51

365
2010 = 27.81
13.13
Inventory

 Inventory turnover ratio

Cost of Goods Sold

Average Inventory

 Average days in inventory

365

Inventory Turnover Ratio

Inventory Turnover Ratio

Hershey
$3,548,896
2011 ($648,953 + 533,622) /2 = 6.00

$3,255,801
200 = 6.18
($533,622 + 519,712) /2

Tootsie Roll
$365,255
2011 ($42,676 + 29,084 + 35,416 + 21,236) /2 = 5.69

$349,334
2010 = 6.18
($35,416 + 21,236 + 35,570 + 20,817) /2

This metric is worsening for both companies.

Both companies turned their inventory at approximately the industry
average.
Days in Inventory
Hershey
365
2011 6.00 = 60.81

365
2010 = 59.04
6.18

Tootsie Roll
365
2011 5.69 = 64.17

365
2010 = 59.05
6.18
Accounts Payable

 Accounts payable turnover ratio

Inventory Purchases

Average Accounts Payable

 Average days payables outstanding

365

Accounts Payable Turnover Ratio

Accounts Payable Turnover Ratio (Nordstrom)

Nordstrom
$6,592 – 201
2011 ($917 + 845) /2 = 7.71

$5,897 – 49
2010 = 7.57
($845 + 726) /2

This metric is worsening for Nordstrom.

Days in payables outstanding (Nordstrom)

Nordstrom
365
2011 7.71 = 47.2 days

365
2010 = 48.2 days
7.57
Summary of Hershey’s Working
Capital Position
1. Customers pay accounts receivable
in approximately 25 days.
2. Inventory remains on hand for
approximately 61 days.
3. Current operations are generating
sufficient cash to repay current
liabilities.
 Summary of Tootsie Roll’s Working
Capital Position
1. Accounts receivable are paid in approximately
29 days.
2. Inventory remains on hand for approximately
64 days.
3. Current operations are generating sufficient
cash to repay current liabilities.
International
Accounting 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 liabilities
2 IAS No. 39, “Financial Instruments: Recognition and
Measurement”
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 liquidity
2 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
 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

 Revised IAS No. 2: LIFO is no longer allowed

 Inventory must be written down to net realizable value on item-by-

item basis
 End of Chapter 8

Prepared by Kathryn Yarbrough, MBA

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