Generally, the company comprises two types of capital, i.e. fixed capital and working capital. The fixed capital has long-term life and includes investment in buildings, land, plants, and machinery. Whereas, the working capital comprises of the investment made by the company to bring all fixed capitals into operations. Once the company brings the factor of productions like cash, raw-material, the working capital cycle begins.
The working capital is the capital of the business that is required for the day to day operation of the business. It is the difference between the company’s current assets and current liabilities. The current assets include cash, account receivables, inventories and latter one includes accounts payables. The working capital assessment helps the company to measure its operational efficiency and short-term financial health. Mathematically, it can be expressed as: -
Net Working Capital(NWC)= Current Asset(CA)-Current Liabilities(CL)……. eqn (i)
Let’s take a hypothetical company XYZ. Pvt. Ltd. and calculate the status of working capital as on 31st December 2017.
Balance Sheet of XYZ. Pvt. Ltd
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As on 31st December, 2017
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Asset
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Amount ($)
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Liabilities and Equity
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Amount ($)
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Current Asset
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1,950.00
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Current Liabilities
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800.00
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Cash in hand
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200.00
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Accounts Payable
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225.00
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Cash at bank
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250.00
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Tax payables
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125.00
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Account Receivables
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500.00
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Sundry Creditors
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375.00
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Sundry Debtors
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300.00
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Provisions
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75.00
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Inventories
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700.00
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Fixed Asset
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32,000.00
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Shareholder Equity
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33,150.00
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Plant and Machinery
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10,000.00
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Capital
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25,000.00
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Less: Depreciation
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1,000.00
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Profit for Current Year
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775.00
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Net Plant and Machinery
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9,000.00
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Retained Earning
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7,375.00
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Building
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20,000.00
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Less: Depreciation
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2,000.00
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Net Building
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18,000.00
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Land
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5,000.00
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Total Asset
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33,950.00
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Total Liabilities and Equity
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33,950.00
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Total Current Assets
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Cash in hand+ cash at bank+ Account Receivable +Sundry Debtors+ Inventories
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A
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1,950.00
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Total Current Liabilities
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Account Payables +Tax Payables +Sundry Creditors+ Provisions
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B
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800.00
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Working Capital (A-B)
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1,150.00
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Therefore, the value of the working capital of company is equal to $ 1150. Similarly, we can also calculate various ratios which depict the short-term solvency of the company.
For example -Current Ratio: CA/CL= 1950/1150=1.69 which is above 1.5 (standard) and is assumed good.
The sunk cost is the cost that has already been incurred and cannot be recovered. It is also called the past cost. These costs are excluded from the future business decisions. These are the incremental cost and are irrelevant for the decision-making process. The sunk cost is also called stranded cost. Some of the examples of the sunk cost are: -
· Marketing study: A company invested $10000 in market study to check the feasibility of its new products. And later it was concluded that the investment is not worth making. The pre-made expenditure of $10000 could not be recovered and is a sunk cost.
· Research and development cost: the billion dollars invested by the pharmaceutical company to develop new medicine are the sunk cost if they are not able to do so.
As per (Roberto, 2009) managers often have the hard time to ignore and admit the sunk cost. Due to their cognitive dissonance and expectation to reap the benefit and to come across previous loss they move on adding funds to complement previous loss but this is not a healthy practice. He further suggests management should promote free conversation among the team, generate constructive tension to analyze the project and define the opportunity cost.
Bibliography
Roberto, M. (2009, November). CUTTING YOUR LOSSES: HOW TO AVOID THE SUNK COST TRAP. Retrieved from www.iveybusinessjournal.com: https://iveybusinessjournal.com/publication/cutting-your-losses-how-to-avoid-the-sunk-cost-trap/
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