The market values of monetary assets are likely to change during periods of inflation. Changes in monetary assets such as cash, trade debtors and trade creditors will affect operating activities of a business.
To avoid a disruption of normal operating business activities, such changes must be indicated in appropriate accounts.
Working capital, which is that part of capital needed to maintain the day to day operation of business is usually affected in inflationary periods. So when there are changes in monetary assets, monetary working capital adjustment becomes necessary.
What is monetary working capital adjustment?
Monetary Working Capital Adjustment (MWCA) is the necessary variation (increase or decrease) made to finance to supply a sufficient level of monetary working capital due to changes in prices.
MWCA is not about a change in the volume of working capital, it is an adjustment that shows the amount of additional finance required to maintain the same level of working capital.
Note that working capital also known as net working capital (NWC), is the excess of current assets over current liabilities.
It’s positive when current assets are more than current liabilities but negative when current liabilities are more than current assets.
Negative working capital is okay for a business operating in the fast moving consumer goods (FMCG) industry, where customers pay cash. The business depends on cash paid upfront by customers to finance operations rather than obtain bank loans.
However, for other businesses where credit sales are necessary for survival, maintaining a negative working capital structure is bad; there is going to be insufficient cash to meet all necessary short term liabilities. This is why monetary working capital adjustment is very important.
How is monetary working capital adjustment calculated?
Cash is usually excluded from the calculation. The reason is, the amount of cash held by a business may have no relations to its operations.
Most businesses use cash for the acquisition of permanent fixed assets. Instead of cash, bank (cash balances) is included in the monetary working capital adjustment.
Let us use the following information to determine monetary working capital adjustment:
|march 31, 2019 ($)||march 31,2020 ($)|
|C||Monetary working capital (C = A – B)||2,300||1,300|
|D||March 31, 2019||150|
|E||March 31, 2020||170|
|F||Average for the year:F =(D + E)/2||160|
Note: indices for creditors and debtors should indicate changes in cost of purchases and cost of sales respectively.
From the table above, the monetary working capital as at march 31, 2019 (historical costs) is $2,300. At average values for the year, it is:
$2,300 x 160/150 = $2,453
From the table, the monetary working capital as at march 31, 2020 (historical costs) is $1,300. At average values for the year, it is:
$1,300 x 160/170 = $1,224.
A look at the historical cost accounts shows that the monetary working capital decreased by $1,000 ($2,300 – $1,300).
But at average values for the year, the monetary working capital decreased over the year by $1,229 ($2,453 – $1,224).
MWCA = $229 – The difference between the changes under the historic and current costs ($1,229 – $1,000).
$229 represents the change in working capital due to changes in price during the year considered.
It is important to keep in mind that MWCA is a reflection of the change in the market value of monetary assets and liabilities, with particular emphasis on sundry debtors and sundry creditors, in the current cost accounts.