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Working Capital Concepts - Page 2 of 2 - MBA Knowledge Base

Working Capital Concepts

Structure of Working Capital

The study of structure of working capital is another name for the study of working capital cycle. In other words, it can be said that the study of structure of working capital is the study of the elements of current assets viz. inventory, receivable, cash and bank balances and other liquid resources like short-term or temporary investments. Current liabilities usually comprise bank borrowings, trade credits, assessed tax and unpaid dividends or any other such things. The following points mention relating to various elements of working capital deserves:

1. Inventories

Inventory is major item of current assets. The management of inventories — raw material, goods-in-process and finished goods is an important factor in the short-run liquidity positions and long-term profitability of the company.

  1. Raw material inventory— Uncertainties about the future demand for finished goods, together with the cost of adjusting production to change in demand will cause a financial manager to desire some level of raw material inventory. In the absence of such inventory, the company could respond to increased demand for finished goods only by incurring explicit clerical and other transactions costs of ordinary raw material for processing into finished goods to meet that demand. If changes in demand are frequent, these order costs may become relatively large. Moreover, attempts to purchases hastily the needed raw material may necessitate payment of premium purchases prices to obtain quick delivery and, thus, raises cost of production. Finally, unavoidable delays in acquiring raw material may cause the production process to shut down and then re-start again raising cost of production. Under these conditions the company cannot respond promptly to changes in demand without sustaining high costs. Hence, some level of raw materials inventory has to be held to reduce such costs. Determining its proper level requires an assessment of costs of buying and holding inventories and a comparison with the costs of maintaining insufficient level of inventories.
  2. Work-in-process inventory— This inventory is built up due to production cycle. Production cycle is the time-span between introduction of raw material into production and emergence of finished product at the completion of production cycle. Till the production cycle is completed, the stock of work-in-process has to be maintained.
  3. Finished goods inventory— Finished goods are required for reasons similar to those causing the company to hold raw materials inventories. Customer’s demand for finished goods is uncertain and variable. If a company carries no finished goods inventory, unanticipated increases in customer demand would require sudden increases in the rate of production to meet the demand. Such rapid increase in the rate of production may be very expensive to accomplish. Rather than loss of sales, because the additional finished goods are not immediately available or sustain high costs of rapid additional production, it may be cheaper to hold a finished goods inventory. The flexibility afforded by such an inventory allows a company to meet unanticipated customer demands at relatively lower costs than if such an inventory is not held.

Thus, to develop successfully optimum inventory policies, the management needs to know about the functions of inventory, the cost of carrying inventory, economic order quantity and safety stock. Industrial machinery is usually very costly and it is highly uneconomical to allow it to lie idle. Skilled labour also cannot be hired and fired at will. Modern requirements are also urgent. Since requirements cannot wait and since the cost of keeping machine and men idle is higher, than the cost of storing the material, it is economical to hold inventories to the required extent.

2. Receivables

Many firms make credit sales and as a result thereof carry receivable as a current asset. The practice of carrying receivables has several advantages viz., (i) reduction of collection costs over cash collection, (ii) reduction in the variability of sales, and (iii) increase in the level of near-term sales. While immediate collection of cash appears to be in the interest of shareholders, the cost of that policy may be very high relative to costs associated with delaying the receipt of cash by extension of credit. Imagine, for example, an electric supply company employing a person at every house constantly reading electricity meter and collecting cash from him every minute as electricity is consumed. It is far cheaper for accumulating electricity usage and bill once a month. This of course, is a decision to carry receivables on the part of the company.

It may also be true that the extension of credit by the firm to its customers may reduce the variability of sales over time. Customers confined to cash purchases may tend to purchase goods when cash is available to them. Erratic and perhaps cyclical purchasing patterns may then result unless credit can be obtained elsewhere. Even if customers do obtain credit elsewhere, they must incur additional cost of search in arranging for a loan costs that can be estimated when credit is given by a supplier. Therefore, extension of credit to customers may well smooth out of the pattern of sales and cash inflows to the firm over time since customers need not wait for some inflows of cash to make a purchase. To the extent that sales are smoothed, cost of adjusting production to changes in the level of sales should be reduced.

Finally, the extension of credit by firms may act to increase near-term sales. Customers need not wait to accumulate necessary cash to purchase an item but can acquire it immediately on credit. This behavior has the effect of shifting future sales close to the present time.

Therefore, the extension of credit by a firm and the resulting investment in receivables occurs because it pays a firm to do so. Costs of collecting revenues and adapting to fluctuating customer demands may make it desirable to offer the convenience associated with credit to firm’s customers. To the extents that near sales are also increased, extension of credit is made even more attractive for the firm.

3. Cash and Interest-bearing liquid assets

Cash is one of the most important tools of day-to-day operation, because it is a form of liquid capital which is available for assignment to any use. Cash is often the primary factor which decides the course of business destiny. The decision to expand a business may be determined by the availability of cash and the borrowing of funds will frequently be dictated by cash position. Cash-in-hand, however, is a non-earning asset. This leads to the question as to what is the optimum level of this idle resource. This optimum depends on various factors such as the manufacturing cycle, the sale and collection cycle, age of the bills and on the maturing of debt. It also depends upon the liquidity of other current assets and the matter of expansion. While a liberal maintenance of cash provides a sense of security, a lack of sufficiency of cash hampers day-to-day operations. Prudence, therefore, requires that no more cash should be kept on hand than the optimum required for handling miscellaneous transactions over the counter and petty disbursements etc.

It has not become a practice with business enterprises to avoid too much redundant cash by investing a portion of their earnings in assets which are susceptible to easy conversion into cash. Such assets may include government securities, bonds, debentures and shares that are known to be readily marketable and that may be liquidated at a moment’s notice when cash is needed.

Source of Working Capital Finance

Conventional generalizations relating to financing of working capital suggest that an amount equal to the basic minimum of current assets should be financed from long-term source and that only seasonal needs of working capital should be financed from short-term sources.21 It is obvious that such an arrangement helps to keep the cost of working capital
finance to the minimum for an enterprise and gives a rise to its rate of return on the total funds employed. Viewed thus, the sources of working finance can be classified into permanent and the current sources of working capital finance.

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