A current flaw in U.S. GAAP/IFRS financial reporting standards distorts the calculation of working capital and the current ratio, understating the liquidity of most companies.
Conventional financial reporting places the current portion of long-term debt (CPLTD) among current liabilities because it is a liability due in the current period. That approach, however, incorrectly implies that CPLTD will be repaid from the conversion of current assets into cash.
The standard balance sheet fails to match the CPLTD with the fixed asset that repays it. To truly “balance” a balance sheet in terms of what is current and what is long term, a new concept is needed—the current portion of fixed assets (CPFA). The CPFA is the portion of the fixed asset that will be used up in the current period to generate revenue. This year’s CPFA is next year’s depreciation expense.
The debt service coverage ratio, used in commercial lending, is an effective tool for measuring repayment of long-term loans. It correctly captures the concept that the use of the fixed asset generates revenue that is used to repay the CPLTD.
Two possible approaches could fix the current distorted liquidity picture: focusing on the trading cycle by taking CPLTD out of current liabilities; or developing a new “current ratio” that leaves CPLTD with current liabilities but calculates CPFA and reports it with current assets. The latter approach would require a change in financial reporting standards.
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