Financial Accounting Theory and Analysis: Text and Cases, 11th Edition

A company's working capital is the net short-term investment needed to carry on day-to-day activities. The measurement and disclosure of working capital on financial statements has been considered an appropriate accounting function for decades, and so the usefulness of this concept for financial analysis is accepted almost without question. This is not to say that the concept does not present some serious problems, namely (1) inconsistencies in the measurements of the various components of working capital, (2) differences of opinion over what should be included as the elements of working capital, and (3) a lack of precision in the meaning of certain key terms involved in defining the elements of working capital, such as liquidity and current. This chapter examines the foundation of the working capital concept, reviews the concept and its components as currently understood, illustrates how the adequacy of a company's working capital position can be evaluated, and discusses how the concept might be modified to add to its usefulness.

Development of the Working Capital Concept

The concept of working capital originated with the distinction between fixed and circulating capital at the beginning of the twentieth century. As noted in Chapter 1, at that time accounting was in its adolescent stage, and such concepts as asset, liability, income, and expense were not clearly understood.