Which of the following rules stands true while preparing a schedule of changes in working capital? (A) An increase in current assets increases working capital (B) An increase in current assets decreases working capital (C) An increase in current liabilities decreases working capital (D) An increase in current liabilities increases working capital Choose the most appropriate answer from the options given below:
A and C only
Understanding Working Capital and its Changes
Working capital is a crucial measure of a company's operational liquidity and short-term financial health. It is defined as the difference between a company's current assets and its current liabilities. The formula for working capital is:
\(\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}\)
A schedule of changes in working capital is prepared to show the increase or decrease in working capital between two periods. This schedule is often part of a funds flow statement or cash flow statement analysis.
Analyzing the Rules for Working Capital Changes
Let's examine each statement provided in the question regarding the rules for preparing a schedule of changes in working capital:
- An increase in current assets increases working capital
- An increase in current assets decreases working capital
- An increase in current liabilities decreases working capital
- An increase in current liabilities increases working capital
Based on the formula \(\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}\), we can analyze how changes in current assets and current liabilities affect working capital.
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Statement A: An increase in current assets increases working capital.
If Current Assets increase while Current Liabilities remain constant, the difference between Current Assets and Current Liabilities (Working Capital) will increase. For example, if Current Assets were 100 and Current Liabilities were 50 (Working Capital = 50), and Current Assets increase to 120 (while Liabilities remain 50), the new Working Capital is 120 - 50 = 70. Working Capital increased from 50 to 70. This statement is True.
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Statement B: An increase in current assets decreases working capital.
As shown above, an increase in current assets leads to an increase in working capital, not a decrease. This statement is False.
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Statement C: An increase in current liabilities decreases working capital.
If Current Liabilities increase while Current Assets remain constant, the difference between Current Assets and Current Liabilities (Working Capital) will decrease. For example, if Current Assets were 100 and Current Liabilities were 50 (Working Capital = 50), and Current Liabilities increase to 70 (while Assets remain 100), the new Working Capital is 100 - 70 = 30. Working Capital decreased from 50 to 30. This statement is True.
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Statement D: An increase in current liabilities increases working capital.
As shown above, an increase in current liabilities leads to a decrease in working capital, not an increase. This statement is False.
Therefore, the rules that stand true while preparing a schedule of changes in working capital are that an increase in current assets increases working capital, and an increase in current liabilities decreases working capital.
Let's summarize the effect of changes:
| Change in Current Account | Effect on Working Capital |
|---|---|
| Increase in Current Assets | Increase in Working Capital |
| Decrease in Current Assets | Decrease in Working Capital |
| Increase in Current Liabilities | Decrease in Working Capital |
| Decrease in Current Liabilities | Increase in Working Capital |
Conclusion
Based on our analysis, statements (A) and (C) correctly describe the impact of changes in current assets and current liabilities on working capital. An increase in current assets increases working capital, and an increase in current liabilities decreases working capital.
Revision Table: Changes in Working Capital Rules
| Statement | Analysis | Truth Value |
|---|---|---|
| An increase in current assets increases working capital | Direct relationship with Working Capital = Current Assets - Current Liabilities | True |
| An increase in current assets decreases working capital | Inverse relationship implied, contradicts formula | False |
| An increase in current liabilities decreases working capital | Inverse relationship with Working Capital = Current Assets - Current Liabilities | True |
| An increase in current liabilities increases working capital | Direct relationship implied, contradicts formula | False |
Additional Information: Schedule of Changes in Working Capital
The schedule of changes in working capital is a component typically used in the preparation of a funds flow statement. It helps in identifying the changes in the individual components of working capital (current assets and current liabilities) between two balance sheet dates. The net change calculated in this schedule (either a net increase or net decrease in working capital) is then shown in the funds flow statement as an application or source of funds, respectively.
- An increase in working capital means that a portion of funds has been used to finance the additional current assets or reduce current liabilities.
- A decrease in working capital means that funds have been released from current assets or by increasing current liabilities.
Understanding these changes is vital for analyzing the sources and applications of funds within a business over a period.
Important Questions from Working Capital
Which of the following statements is related to the 'Human Capital Theory'?
As per which one of the following approaches, a firm finances a part of its permanent working capital with short term financing?
Negative Net Working Capital implies that :
Which one of the following will have a net change in the amount of working capital of a company?
Which of the following factors determine the requirements of working capital of a firm?
a. Nature of Business
b. Technology and Manufacturing Policy
c. Management Skills
d. Credit Policy
e. Market and Demand Conditions
Choose the correct answer from the options given below:
