Question

Over the past year, a firm decreased its current assets and increased its current liabilities. As a result, the firm's net working capital:

1) Increased
2) Decreased
3) Remained unchanged
4) Cannot be determined

Answer 1

The net working capital of a firm decreased because the firm's current assets were reduced, and its current liabilities were increased, leading to a smaller difference between the two.

Step-by-step explanation:

When a firm decreases its current assets and increases its current liabilities, the result is a decrease in the firm's net working capital. Net working capital is calculated as current assets minus current liabilities. When current assets are reduced and current liabilities are increased, the difference between the two becomes smaller, leading to a lower net working capital. Therefore, the correct answer is 2) Decreased.

In terms of a T-account, which is a visual representation of the financial positions of a company, a decrease in assets would be shown on the left side of the T, while an increase in liabilities would be recorded on the right side.

Since the net worth or equity of a company is a reflection of assets minus liabilities, any decrease in net working capital negatively impacts the net worth. In practice, if a bank, for instance, reduced its reserves and increased what it owes to depositors, this action would reflect in diminished net working capital.