Limitations of Working Capital Concept of Funds

In this article we will discuss about the limitations of working capital concept of funds.

One of the limitations of working capital concept of funds is that it omits a few major financial and investment transactions. Important information regarding changes in the resources of the firm and in the financial structure of the firm are omitted.

Such items do not, of course, affect net working capital, but if included, would certainly provide quantitative and analytical information for decision-making. For example, issuing equity shares, or debentures for purchase of buildings or plant and machinery has no effect on working capital, but is a significant financial transactions that should be disclosed.

Under the total financial resources concept of funds, the statement is not limited to transactions affecting working capital but would also be extended to cover all significant financial transactions that would otherwise be omitted under the other concepts of funds. That is, the total financial resources concept requires that all material financial transactions be disclosed in the statement of changes in financial position.

Transactions that technically do not increase or decrease funds (regardless of the concept of funds employed) but that represent significant financing and investing activities entered into by an entity must also be disclosed within the statement.

Disclosure of a significant transaction that does not increase or decrease funds is made by showing one side of the transaction as a source of funds and the other side of the transaction as a corresponding use of funds.

Transactions that affect financial position but do not increase or decrease funds include the following:

(a) Purchase of non-current assets, e.g., property and equipment by issuing share capital or debenture or long term debt.

(b) Reduction of a long-term liability by the issuance of share capital or the incurrence of another long-term liability or a reduction in a non-current asset.

The above statement would be more useful in summarizing the resources from which the funds have been obtained and the uses to which they have been put.

The statement can analyse sources and uses in two categories of items:

(i) Those which affect working capital

(ii) Those which do not affect working capital.

Such a statement is, certainly, more informative and, therefore, potentially more useful in disclosing the firm’s financing and investing activities during the two balance sheet dates.

The fact that items which do not affect working capital are separately dealt with, implies that it retains all the advantages of the working capital concept and, in addition, has the additional advantage of providing a complete picture of the total financial and investment activities of the firm.

This statement includes significant transactions involving flows of non-cash resources even if cash itself is not affected. To recognise changes in all resources, these transactions are reported as both sources and uses of cash.

The following illustration explains it:

It can be noticed that each side of the transactions has a significant impact on the company’s financial position. By applying the total resources concept, the statement of changes in financial position reflect more fully these significant events.

Limitations of Statement of Changes in Financial Position, on Total Resources Basis:

The statement of changes in financial position, on total resources basis, has the following limitations:

Firstly, the concept of financial resources is vague and ill defined. The separate items included in the classification of sources and applications of funds do not necessarily represent increases and decreases of resources. Therefore, there is no direct disclosure of the extent to which the total resources of the firm have changed during the period.

Secondly, acquisitions of property in exchange for shares cannot be measured with the same degree of reliability as assets acquired for cash. Therefore, the summation of gross additions to plant and equipment for example, may result in misleading interpretations of the amount of resources acquired.