Working Capital

Question: Previously, the current ratio (current assets divided by current liabilities) and the amount of

working capital (current assets minus current liabilities) were discussed. Are there additional vital signs that

relate to current liabilities that should be analyzed when looking at an organization?

Should decision makers be aware of any specific ratios or amounts in connection with current liabilities that

provide especially insightful information about a company’s financial health and operations?

Answer: In studying current liabilities, the number of days a business takes to pay its accounts payable is a figure

of interest. If a business begins to struggle, the time of payment tends to lengthen because of the difficulty in

generating sufficient cash amounts. Therefore, an unexpected jump in this number is often one of the first signs

of financial problems and warrants concern.

To determine the age of accounts payable (or the number of days in accounts payable), the amount of inventory

purchased during the year is first calculated:

cost of goods sold = beginning inventory + purchases – ending inventory,

Thus,

purchases = cost of goods sold – beginning inventory + ending inventory.

Using this purchases figure, the number of days that a company takes to pay its accounts payable on the average

can be found. Either the average accounts payable for the year can be used below or just the ending balance.

purchases/365 = average purchases per day

accounts payable/average purchases per day = average age of accounts payable

As an illustration, the following information comes from the 2008 financial statements for Safeway Inc.

Figure 13.18 Information from 2008 Financial Statements for Safeway Inc.

The total of inventory purchases by Safeway during 2008 was over \$31 billion:

purchases = cost of goods sold – beginning inventory + ending inventory

purchases = \$31.589 billion – \$2.798 billion + \$2.591 billion

purchases = \$31.382 billion.

The average purchases amount made each day during 2008 by this company was nearly \$86 million:

purchases/365

\$31.382/365 = \$85.978 million.

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