TT1 Initial Capital Contribution

Typical Transaction 1

Example: Increase Initial Capital by One Million

The entries for this transaction in the Accounting System can be seen here, in the AccountingLab and in the Accounting System, Operation O1, M1:

Accounting Equation
Initial Capital Contribution Increase Asset (Cash at Bank) (+)
Increase Equity (+)
> Enter 1’000,000 in field “Add value”
> Double entry: Debit entry, Cash at Bank balance increases by one million to 1’758,550. Credit entry, Equity balance increases by one million to 1’767,550
> Values in red show Balance Sheet values before and after changes
Balance Sheet Y1
Balance Sheet
Original After Changes
Current Assets  767,850  1’767,850
Bank 758,550  1’758,550
Debtors and Prepayments 9,300  9,300
Other Current Assets (Stock)  0  0
Fixed Assets 44,000  44,000
TOTAL ASSETS 811,850  1’811,850
Current Liabilities  44,300  44,300
Creditors  44,000  44,000
Accruals 300  300
Long Term Liabilities  0  0
Long Term Loan 0  0
Equity  767,550   1’767,550
Shareholders’ Equity 800,000  1’800,000
Income Statement -32,450  -32,450
TOTAL Liabilities + Equity + Retained Earnings 811,850  1’811,850
Liquidity analysis: calculation of Current Ratios before and after entering the new additional capital of 1’000,000
Current Ratio (CR) → Current Assets (CA) / Current Liabilities (CL) → CR = CA / CL

An analysis of financial ratios can be seen here.

Calculation of Current Ratio
Initial Capital Current Assets Current Liabilities Current Ratio
Balance Sheet Original 800,000 767,850 44,300 767,850 / 44,300 = 17.3
Balance Sheet New 1’800,000 1’767,850 44,300 1’767,850 / 44,300 = 39.9

The addition of capital changes the current ratio as cash at bank increases but creditors nor accruals change, thus, current liabilities do not change. The current ratio increases due to the increase of cash at bank.

The current ratios in the example, 17.3 and 39.9 are far above the normal ratios of trading firms. An absolute minimum current ratio would be above 1.0, meaning that there would be sufficient current assets to cover current liabilities.

However, when we analyse risk, expected Cash at Bank may easily not happen due to lesser sales, delays in receiving payment from debtors, higher operating costs, currency devaluation, and higher borrowing costs. These would deplete cash without reflecting this higher expense in higher sales. Thus, current assets will be smaller than projected, falling below the value of current liabilities. The current ratio then may be below 1.0.

In practical terms a current ratio lower than 1.0 indicates difficulties to pay current obligations, such as creditors and accruals, in the short term the company may become insolvent and even be forced to go bankrupt, if even salaries cannot be paid!

A more common minimum current ratio in commerce and industry would above 2.0 although it will depend on the nature of the business.

Some types of businesses usually operate with a current ratio less than one. For example, if inventory turns over much more rapidly than creditors become due, then the current ratio will be less than one. This can allow a firm to operate with a low current ratio. A grocery has a much higher turnover than a manufacturing firm thus the grocery needs sufficient cash to pay daily suppliers of groceries, vegetables, fruit, etc. and the inventory levels are low as they rotate fast. The composition of current assets in this case is for a predominance of cash over inventory.

Low values of current ratios, however, may not indicate a critical problem. If an organisation has viable long-term prospects, it may be able to borrow against those prospects to meet current obligations.

If all other things were equal, a creditor, who is expecting to be paid in the next 12 months, would consider a high current ratio to be better than a low current ratio, because a high current ratio means that the company is more likely to meet its liabilities which fall due in the next 12 months. You should view the relation between the operation cycle period and the current ratio.

The main lesson to learn for cash management when having high current ratios, meaning excess liquidity is that it is unwise and costly to keep unused cash balances as the capital can always be employed more productively and profitably that just “parking” the money at the bank.

This is one of the important benefits of performing current ratio analysis as it informs of any financial malpractice as is the case in the present exercise where the company has been provided with a high injection of capital, well above the current cash needs, instead of the fund being invested elsewhere in bank deposits or bonds earning interest. The latter is foregone when investing high above the company cash needs.

In this example equity does increase by one million but is not part of the current ratio calculation.

Quick Ratio (CR) → (Current Assets (CA) minus (Inventory) / Current Liabilities (CL) → CR = (CA – Inventory) / CL
Calculation of Current Ratio
Initial Capital Current Assets Current Liabilities Quick Ratio
Balance Sheet Original 800,000 767,850 44,300 767,850 / 44,300 = 17.3
Balance Sheet New 1’800,000 1’767,850 44,300 1’767,850 / 44,300 = 39.9

The discussion on quick ratio is similar to the discussion on Current Ratio above, as the company in the example does not carry any inventory, namely, Stock is zero in the Balance Sheet, thus Current Assets do not change, nor Current Liabilities, these are the same that the amounts used to calculate the Current Ratio.

Working Capital → Current Assets (CA) minus Current Liabilities (CL) → Shows funds available after paying short term obligations
Calculation of Current Ratio
Initial Capital Current Assets Current Liabilities Working Capital
Balance Sheet Original 800,000 767,850 44,300 767,850 – 44,300 = 723,550
Balance Sheet New 1’800,000 1’767,850 44,300 1’767,850 – 44,300 = 1’723,550

The amount of working capital in the original balance sheet, 723,550, has increased by one million to 1’723,550 in the new balance sheet, equal to the increase in capital as there is only an increase in cash at bank by the same amount. There is no any other a transaction changing current assets or current liabilities.

Regarding efficient cash management and the reasonableness of having a very high amount of working capital, by injecting more cash than needed for the operation of the firm, please refer to the above discussion on high values of current ratios. Excessive amounts of working capital have the same negative financial effects than very high Current Ratios.