This question is from Curriculum 2013 Book 3 - Page 583 OR Curriculum 2014 Book 3 - Page 614.
I couldn’t understand why Working Capital for Year Zero = $100. Moreover, I couldn’t understand why Line 16 is computed. I could understand how it is computed – i.e. it’s simply the change in working capital Line 9 from year to year.
Moreover, I also saw that the book has used the change" in working capital in calculating cash flows. This is something new to me. I haven’t seen using Current Assets - Current Liabilities to calcuate cash flows. I am not sure why this is done. Is the change in working capital a CFO? CFI? or CFF? I am completely lost on this one.
It has been mentioned in the question that equity capital of $100 has been invested immediately in working capital. This tell us that for the Start of Year 1 (i.e. Year 0) we will be having $100 in working capital ( i.e. Net Current Assets). Perhaps we can look at the accounting equation:
A - L = E ------------------------(1)
(CA + NCA) - (CL + NCL) = E -------------(2) where (CA= Current Asset; CL= Current Liability; NCA= Non-Current Asset and NCL= Non-Current Liability)
Since there are no mention of any NCA and NCL, we can further refine equation (2) into:
CA - CL = E ---------------(3)
Finally we have:
Working Capital = Owners’ Equity
and this satisfy what the question says from the start that equity capital of $100 has been invested directly in working capital.
Well at the End of year 1, the working capital will be 90% of the period’s sales figures. This follows:
Y1: $90
Y2: $99
Y3: $108.9
Y4: $119.8
Y5: $131.8
Actually, change in working capital is equivalent to the sum of adjusting for change in current assets account and change in current liability. Let us consider the following hypothetical financial statements:
I ncome Statement:
Net Income = $1000
Balance Sheet
20X0() 20X1()
Account Receivables(AR) 100 200
Account Payables(AP) 50 100
Using the indirect method to compute CFO:
(1)Net Income: $1000
(2) Less Increase in AR: ($100)
(3) Add Increase in AP: $50
(4) NET CFO: $950
Line (2) and (3) can be lumped together and give a net amount of $(50) which give a NET CFO of 950 too. In which case the amount of (50) is the change in working capital.
Generally, CFO cover both current assets and current liabilities in the balance sheet.
