This article was first published in Edition 8 (January 2014) of Accountancy Futures, ACCA's research and insight journal.
With the increasing frequency of cross-border flows of capital and commodities, the operation of working capital has become just as important a business activity as the goods and services it underpins.
An in-depth change in business and financial concepts is now brewing, and the concept of working capital and the related performance assessment system need to be reviewed. The unpredictable economic environment also requires businesses to pay great attention to the financial risks related to working capital, and the change in the concept of financial risks will drive innovation in the assessment models.
redefining working capital
An enterprise’s economic activities can be divided into operating, investing and financing activities. Traditional finance and accounting theory classifies these activities as operating (procurement, production, marketing, etc) or financial (investing and financing). This classification reduces the concept of working capital mainly to such operating activities as inventory, accounts receivable and payable.
Yet operating and investing activities both create value by using the company’s funds. The scope of business activities should therefore be broadened to be value-creating activities through the use of funds, including the two categories of operating and investing activities.
Likewise, all a company’s economic activities should be classified as business activities or financing activities. The former involve using the company’s capital, the latter refer to the funding that underpin these business activities.
Using this broader concept, working capital not only refers to the balance between current assets and current liabilities in operating activities (or total economic activities), but also to the balance between current assets and current liabilities in a company’s business activities. Because a company uses its capital either for operating or investment activities, the current assets in business activities should refer to the total current assets. Therefore:
Working capital = current assets in business activities – current liabilities in business activities = current assets – current liabilities in business activities
With the broadened business concept, the capital allocation efficiency decides how capital is split between operating activities and investing activities. Currently, the commonly used working capital management performance evaluation indicators are days inventory/sales/payables outstanding (DIO, DSO, DPO), days working capital (DWC), cash conversion cycle (CCC), etc. These indicators reflect neither the management philosophy of the integration of operation and finance, nor evaluate the performance of investing activities.
In the future, working capital for operating activities should be classified according to its relationship to the supply chain or channels as ‘working capital for marketing channels, production or internal operating channels, and procurement channels’.
To help improve working capital performance by optimising the supply chain and to better reflect a working capital philosophy that integrates operation and finance, we must design a channel-based performance evaluation system. Its major indicators would be the working capital cycles of marketing channels, production/internal operating channels, and procurement channels.
Marketing channels working capital cycle = marketing channels working capital ÷ (operating revenue / 365)
Production or internal operating channels working capital cycle = production or internal operating channels working capital ÷ (operating revenue / 365)
Procurement channels working capital cycle = procurement channels working capital ÷ (operating revenue / 365)
Operating activities working capital cycle = marketing channels working capital cycle + production or internal operating channels working capital cycle + procurement channels working capital cycle
New indicators should also be set to reflect working capital performance in investing activities. The performance evaluation for investing activities should overcome the limitations of using operating revenue as a measure of capital turnover. We should use cashflow indicators such as cash received from investment recovery and from investment income as the measure for the turnover of investing activities working capital. Namely:
Investing activities working capital cycle = investing activities working capital ÷ [(cash received from investments recovery + cash received from investment income) / 365]
New risk model
Existing risk assessment studies have narrowly interpreted financial risks as the enterprise’s solvency. Thus liquidity ratio, quick ratio, debt ratio, financial leverage and other indicators have become the common measures of financial risk. But all financial failures are ultimately reflected in breaks in the funding chain that result in operating difficulties – the company can’t amass enough working capital to support its business activities.
Accordingly, the core meaning of financial risks should focus on the uncertainty of the ability to guarantee the needs of working capital. We should therefore develop a new model for the assessment of financial risks to remedy the defects of the old solvency-focused model.
If we define the corporate financial risk assessment as the ability of funding activities to guarantee the working capital needs of the enterprise, then we can examine the corporate financial risk assessment according to the quantity and quality of guarantee. ‘Guarantee quantity’ refers to the amount of funds raised while ‘guarantee quality’ refers to the sustainability or stability of those funds.
If the balance between a company’s current assets and all its current liabilities is called the ‘working fund’, then:
Working fund = current assets – current liabilities = long-term liabilities + owner’s equity – non-current assets
Working capital = current assets – current liabilities in business activities = working fund + current liabilities in funding
In other words, working capital equals the sum of the funding-related current liabilities and the working fund; the former represent the working capital received from short-term funds (short-term loans), and the latter the working capital raised from long-term funds (long-term liabilities and owners’ equity).
Therefore, the guarantee quality of a company’s funding activities can be measured by the proportion of the working fund in its working capital. The higher the proportion, the better the guarantee quality and the lower the financial risks because long-term fund sources are more sustainable and stable than short-term financial liabilities.
Professor Wang Zhuquan is vice dean of the Management College of Ocean University of China and dean of the accountancy department, director of China Business Working Capital Management Research Center and candidate president of the Education Branch of the China Accounting Society. He is mainly engaged in research on working capital management and stakeholder accounting.