Estimation of Working Capital 271Inventory
It normally constitutes a major portion of current assets. Inventory is simple insurance against fluctuations
in demand for the firm’s product. Inventory is of three types: raw material, work-in-progress, and finished
goods. Inventory, like any other asset, needs to be managed well. Too much of inventory results in lower prof-
itability as money is locked up in redundant assets which earn no return, and too little inventory results in
loss of sales or customer goodwill. So there is a trade-off between profitability and liquidity.
Accounts Receivable
Most businesses sell goods on credit. When goods are sold, inventories are reduced and accounts receivable
are created. A firm may not have an option regarding its credit granting decision, depending on the product
market condition. In industries that are fiercely competitive—like cement, abrasives, cutting tools, etc.—a
company may have to simply match industry standards to protect sales. Thus, accounts receivable is an
essential investment. Like other components of current assets, there is an optimal level of investment in
accounts receivable beyond which profits deteriorate. In other words, the marginal profits from increased
sales should be greater than the marginal cost of credit.
The credit policy of a firm has four components:
- Credit period
- Credit standards
- Discount policy
- Collection policy
Each of these will be discussed in the subsequent chapters.
Accounts Payable
As the name suggests, it is the credit accepted from suppliers of raw material, components, etc. It is one of
the sources of short-term financing. There is no explicit cost involved with trade credits although the supplier
may lead the cost of money tied up in the price that he charges. It can be easily arranged unlike a loan but one
should be careful not to stretch trade credits too far because it may result in loss of suppliers.
Measuring Working Capital
Net working capital is defined as the difference between current assets and current liabilities. Consider the
following figures:
(Rs crore)Current assets 1999 2000 Current liabilities 1999 2000
Cash 10 29 A/C payable 70 125
Receivables 140 196 Current portion of L.T debt 10 53
Inventory 170 306 Accrued expenses 125 155
Taxes Payable 15 20
320 531 220 353