Benjamin, Harold S.

English

eGrove (Univ. of Mississippi)

Journal of Accountancy Volume 67 Issue 6 Article 5 6-1939 Current Ratio or Net Working Capital? Harold S. Benjamin Follow this and additional works at: https://egrove.olemiss.edu/jofa  Part of the Accounting Commons Recommended Citation Benjamin, Harold S. (1939) "Current Ratio or Net Working Capital?," Journal of Accountancy: Vol. 67: Iss. 6, Article 5. Available at: https://egrove.olemiss.edu/jofa/vol67/iss6/5 This Article is brought to you for free and open access by the Archival Digital Accounting Collection at eGrove. It has been accepted for inclusion in Journal of Accountancy by an authorized editor of eGrove. For more information, please contact egrove@olemiss.edu. Current Ratio or Net Working Capital?BY HAROLD S. BENJAMINWhat is the proper means by which to compare the financial strength of business enterprises at various dates? Is it the ratio which current assets bear to current liabilities (current ratio), or is it the excess of current assets over current liabilities (net working capital) ? Two well known economists recently were engaged in a dispute about that question. Professor Gerhard Colm, in an article on “The Revenue Act of 1938 ”1 cites an in­crease in the net working capital of the leading American industrial corpora­tions to support his contention that these corporations were at least as well equipped in 1938 as they were in 1935, to finance, out of their own resources, an increase in plant and equipment, if business conditions made such an in­crease advisable. His interpretation has been vigorously assailed by another economist, who points to the lowered current ratio, the reduced cash, and the increase in current liabilities. The fig­ures on which both sides base their arguments, Standard Statistics “Com-, posite Balance-sheets of Leading Amer­ican Industrial Corporations,’’2 are shown on the following page.2 Standard Corporation Records, Vol. 15, No. 3342, Aug. 13, 1937, and Standard Trade andSecurities, Vol. 88, No. 19, June 3, 1938. The sample comprises 399 corporations in 1934 and 385 corporations in 1937. This decrease in the number of corporations reduces the total assets and total liabilities by less than 2 per cent so that the comparability of the figures is not materially affected.Before attempting to decide what the correct interpretation of these figures is, let me illustrate by means of a more simple example the meaning of both current ratio and net working capital.A client of mine, for whom I had to prepare an accountant’s report, had not been very successful during the year1 Social Research, Sept. 1938, p. 270.ended June 30, 1938. His volume of sales had declined, and his net loss had exceeded the depreciation charges so as to impair the working capital. At the beginning of the year, cash, inventories, and accounts and notes receivable had amounted to $80,000, and current liabilities to $40,000. At the end of the year, current assets were only $50,000 and current liabilities had been reduced to $17,000. The only favorable fact I could find was that the current ratio had improved from two to one to ap­proximately three to one. But was there any real improvement? The working capital had been reduced from $40,000 to $33,000. An ensuing upswing in busi­ness would probably raise receivables to the previous year’s level, and the client would probably like to increase his in­ventory to what it had been one year before. But he could do so only by re­ducing his cash or increasing his liabili­ties beyond the prior year’s level, unless profits appeared quickly enough to compensate for the loss suffered. The higher current ratio was a result of the depression, and would disappear with returning prosperity. The decisive fac­tor was the reduced working capital. This impairment could be recouped only through new capital contribution, through future profits, or through liqui­dation of fixed assets.For the leading American corpora­tions, from the end of 1934 up to the summer of 1937, a development took place exactly opposite to the one which my client experienced in 1937-1938. Inventories and receivables of those corporations were low in 1934, current liabilities accordingly small, and cash holdings very substantial. But if we want to determine how much the cor­porations had available in 1934 for in­vestment in plant and equipment, we have to subtract from cash the amount364Current Ratio or Net Working Capital?1934 1937Assets:Property account (less depreciation reserve). . 13,765 14,256Investments........................................................... 2,481 2,371Intangibles............................................................. 679 573Other fixed assets................................................. 474 418Cash and equivalent............................................ 3,136 2,816Receivables............................................................ 1,642 2,212Inventories............................................................. 4,442 5,914Total current assets..................................... 9,220 10,942Total assets................................................... 26,619 28,560Liabilities:Funded debt.......................................................... 2,769 2,478Preferred stock..................................................... 3,352 3,217Common stock and surplus................................. 17,256 18,785Capital reserves................................................... 995 730Other liabilities..................................................... 585 649Total current liabilities....................................... 1,662 2,701Total liabilities............................................. 26,619 28,560Net working capital (excess of current as-sets over current liabilities)..................... 7,558 8,241Current asset ratio (ratio of current as-sets to current liabilities)......................... 5.5 4.1which, in case of the hoped-for upswing in business, would be converted into re­ceivables and inventories. If we deduct from the corporations’ cash holdings as of the end of 1934 the amount which would be required if inventories and re­ceivables were to be brought back to their level of 1928, we find that current liabilities exceed cash, whereas at the end of 1937, when inventories and re­ceivables taken together were beyond the high level of 1928 so that no such earmarking of funds was necessary, cash was in excess of current liabilities. Professor Colm, therefore, is right. The leading American industrial corpora­tions were better equipped at the end of 1937 than they were at the end of 1934 to finance a limited period of prosperity by their own means.We have arrived at our conclusion bycomparing amounts which we computed by deducting from the excess of cash over current liabilities, the amounts by which receivables and inventories were below normal or prosperity level. This is, in effect, nothing but a comparison of the amounts of net working capital of the corporations.The current ratio is a valuable ex­pedient for comparing the financial position of enterprises engaged in the same line of business as of the same date, or of the same enterprise at vari­ous times of similar business conditions. However, to trace the changes in the financial strength of enterprises through the various phases of the business cycle, we must use the amount of net working capital, or, if the size of the enterprise has changed, the ratio which net work­ing capital bears to total assets.365

Current Ratio or Net Working Capital?

https://egrove.olemiss.edu/cgi/viewcontent.cgi?article=4147&context=jofa

Current Ratio or Net Working Capital?

Abstract

Similar works

Full text

Available Versions

eGrove (Univ. of Mississippi)