Working Capital.Costs associated with inventory - Essay Example

Week4 DQs Define the purpose of working capital. How does extending credit affect working capital requirements and the cash conversion period (cycle) Evaluate the consequences of inventory costs on Working Capital needs and the Cash Conversion Period. Working Capital refers to the current cash a company holds to pay off the costs for its daily operations, and uses it to finance the manufacture of the desired product from the raw materials. The most important assets involved in Working Capital are inventory, accounts payable and, receivable.

These items indicate the firm's financial position. (McClure, 2008) If a company extends credit to its customers, and they are not able to pay off their invoices on time, working capital of the company gets trapped; meaning that it is part of accounts receivable but cannot be used for immediate purposes. The longer the company has to wait for its payments, the longer the capital is unavailable for further investment.

(McClure, 2008) The Cash Conversion Period refers to the speed of transformation of cash at hand into more cash. Therefore, the lower this value, the better for the company. The cash is first converted to inventory, accounts payable, sales, accounts receivable, and then back to cash again. Extending credit is actually accounts receivable. So if buyers delay payment, the CCP value rises with a fall in the company's efficiency. (Mueller, 2008) Inventory costs will definitely increase need for working capital, as inventory is an important part of it.

The company will have to sell the goods rapidly in order to fulfill other purposes of the working capital. The costs won't have any effect on the Cash Conversion Period if the company is able to sell the goods, and receive all its invoices on time. 2) What are the costs associated with inventory Why is controlling turnover in the inventory important How can improvements in inventory management impact profitability Two kinds of costs are associated with inventory management: Carrying cost of inventory, which includes things like rent, storage, utilities, insurance, labor costs, taxes, investment, pilferage, rework, breakage, spoilage, etc.

Ordering cost of inventory, which includes capital consumed in placing an order for the product, or setting up the machinery required for its manufacture. Shortage cost of inventory, which includes costs incurred when the stock available is insufficient to meet the demand. (Arsham, n.d) Suppliers having low gross margins like about 20-30% should turn their stocks more, while suppliers gaining a larger gross margin can afford to turn their stock less often. A low turnover implies poor sales leading to more inventory, while a high turnover indicates either more sales or inefficient buying.

Larger inventory indicates an investment with a return of zero, and also can incur loss on the firm if the prices should fall. (Investopedia, 2008) In order to improve turnover, less goods should be bought more often from the supplier. Due to the limited capital available for inventory, the goods bought should be sold in order to produce funds required to pay off utility costs, and make a profit. Turnover measures circulation of goods through the firm, and is thus a scale for success. (Schreibfeder, n.d) Steps to be taken to improve profitability include, stopping pilferage, keeping record of all goods, preparing paperwork on time, maximizing inventory turnovers, setting reasonable objectives for buyers, etc.

All these actions can minimize the unnecessary losses incurred by the company and use it to its maximum potential. (Schreibfeder, n.d) Works Cited Arsham, Hossein. (n.d). Economic Order Quantity and Economic Production Quantity Models for Inventory Management. Retrieved March 18, 2008, from EOF, 1994-2008. Website: http://home.ubalt.edu/ntsbarsh/Business-stat/otherapplets/Inventory.htm Inventory Turnover. (2008). Retrieved March 18, 2008, from Investopedia, a Forbes Media Company. Website: http://www.

investopedia.com/terms/i/inventoryturnover.asp McClure, Ben. (2008). Working Capital Works. Retrieved March 18, 2008, from Investopedia, a Forbes Media Company. Website: http://www.investopedia.com/articles/fundamental/03/061803.asp Mueller, Jim. (2008). Understanding The Cash Conversion Cycle. Retrieved March 18, 2008, from Investopedia, A Forbes Media Company. Website: http://www.

investopedia.com/articles/06/cashconversioncycle.asp Schreibfeder, Jon. (n.d). Implementing Effective Inventory Management. Retrieved March 18, 2008, from Effective Inventory Management, Inc. Website: http://www.effectiveinventory.com/article3.html Schreibfeder, Jon. (n.d). Why is Inventory Turnover Important Retrieved March 18, 2008, from Effective Inventory Management, Inc. Website: http://www.

effectiveinventory.com/article2.html