Working capital traditionally has been considered as a positive component of the balance sheet. That is, good performance for the current ratio has been considered as a result well in excess of 1:1, with the higher the numerator, the better; similar results hold for the other working capital ratios.
For example, $3 million of current assets compared to $1 million of current liabilities is a current ratio of 3:1, or a three times "cover".
This thinking has been driven by the attitude of lenders and financial analysts that working capital constitutes a store of value for repaying such debts as borrowings. Bankers are trained to look at financial ratios and demand numbers that exceed preset standards. Often this demand is to enable the bank to forcé a company to borrow to put more cash on the balance sheet, thereby growing the bank´s loan portfolio.
The newer view is that working capital in undesirable because it constitutes a drag on financial performance. Current assets that do not contribute to ROE hinder the performance of the company, and hide obsolete inventory that may not be saleable, receivables that may not be collectible, and other problems.
The emphasis is now on reducing current asset accounts to the point that current liabilities can be funded from ongoing operations of the business. That is, cash collected from sales is used to pay for payables and payroll, with the mínimum in idle current asset accounts.
The concept of working capital as a hindrance to financial performance is a complete change in attitude from earlier conventional wisdom.
However, working capital has never actually contributed to a company´s profits or losses; instead, it sits on the balance sheet awaiting disposition. No profits are directly generated by cash or accounts receivable, and inventories provide returns only when sold at prices above cost.
In fact, there is a significant cost in carrying working capital, which can be calculated using the cost of capital.
Note.- working capital is the arithmetic difference between two balance sheet-aggregated accounts: current assets and current liabilities.
Sources: Own and "Essentials of Working Capital Management" by James S. Sagner.
For example, $3 million of current assets compared to $1 million of current liabilities is a current ratio of 3:1, or a three times "cover".
This thinking has been driven by the attitude of lenders and financial analysts that working capital constitutes a store of value for repaying such debts as borrowings. Bankers are trained to look at financial ratios and demand numbers that exceed preset standards. Often this demand is to enable the bank to forcé a company to borrow to put more cash on the balance sheet, thereby growing the bank´s loan portfolio.
The newer view is that working capital in undesirable because it constitutes a drag on financial performance. Current assets that do not contribute to ROE hinder the performance of the company, and hide obsolete inventory that may not be saleable, receivables that may not be collectible, and other problems.
The emphasis is now on reducing current asset accounts to the point that current liabilities can be funded from ongoing operations of the business. That is, cash collected from sales is used to pay for payables and payroll, with the mínimum in idle current asset accounts.
The concept of working capital as a hindrance to financial performance is a complete change in attitude from earlier conventional wisdom.
However, working capital has never actually contributed to a company´s profits or losses; instead, it sits on the balance sheet awaiting disposition. No profits are directly generated by cash or accounts receivable, and inventories provide returns only when sold at prices above cost.
In fact, there is a significant cost in carrying working capital, which can be calculated using the cost of capital.
Note.- working capital is the arithmetic difference between two balance sheet-aggregated accounts: current assets and current liabilities.
Sources: Own and "Essentials of Working Capital Management" by James S. Sagner.
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