DIGESTING FINANCIAL STATEMENTS: WORKING CAPITAL
Analysts and investors look at the working capital and its trends to measure a company’s financial performance. This metric determines a business’ efficiency and short-term financial capacity by subtracting current assets from current liabilities. Creditors and lenders, however, are concerned about an entity’s capability to repay all its debts. Defensiveness, in the simplest terms.
Inventory speaks volumes since inventory cost accounting affects gross profit margins that is trailed by market players. Conversely, we should bear the inventory costing technique is dependent of gross profit margins. There are three items indicated in inventory: LIFO reserve, net sales, and cost of goods sold.
Cash conversion cycle is another factor to be considered. This metric reveals the firm’s overall financial situation by gauging the average number of days for a company to convert resources into income. The cycle includes days inventory outstanding (DIO), days payable outstanding (DPO), and days sales outstanding (DSO). The cash is not collected until the firm sells its inventory and collects receivables.
Receivables, as seen on the balance sheet, pertain to all unsettled dealings, debts, or other obligations owed by consumers or borrowers. Having said that, higher DIO and DSO use more working capital. But DPO are deducted to help make up the working capital needs. In other words, DIO + DSO - DPO = CCC.
Although most working capital accounts are direct, be wary of the following: derivatives and off-balance-sheet financing. The rules encompassing derivatives are complicated, but let’s put it this way: working capital accounts include derivative instruments. If a derivative is used for hedging, its value will influence the hedged asset’s carrying value.
How to assimilate the working capital of a business? Evaluate the cash conversion cycle, inventory, derivatives’ current accounts, and inventory costing system.
The next tutorial session will focus on long-lived assets.
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