The need for working capital (gross) or current assets cannot be overemphasized. Given the objective of financial decision making to maximize the shareholders wealth, it is necessary to generate sufficient profits. The extent to which profits can be earned will naturally depend, among other things, upon the magnitude of the sales. A successful sales programmed is, in other words, necessary for earning profits by any business enterprise. However, sales do not convert into cash instantly, there is invariably a time lag between the sale of goods and the receipt of cash. There is, therefore, a need for working capital in the form of current assets to deal with the problem arising out of the lack of immediate realization of cash against goods sold. Therefore, sufficient working capital is necessary to sustain sales activity. Technically, this is referred to as the operating or cash cycle. The operating cycle can be said to be at the heart of the need for working capital. The continuing now from cash to suppliers, to inventory, to accounts receivable and back into cash is what is called the operating cycle. In other words, the term cash cycle refers to the length of time necessary to complete the following cycle of events:

1. Conversion of cash into inventory;

2. Conversion of inventory into receivables;

3. Conversion of receivables into cash.

The operating cycle, which is a continuous process,



If it were possible to complete the sequences instantaneously, there would be no need for current assets (working capital). But since it is not possible, the firm is forced to have current assets. Since cash inflows and outflows do not match, firms have to necessarily keep cash or invest in short term liquid securities so that they will be in a position to meet obligations when the become due. Similarly, firms must have adequate inventory to guard against the possibility of able to meet demand for their products. Adequate inventory, therefore, provides a against being out of stock. If firms to be competitive, they must sell goods to their custom credit which necessitates the holding of accounts receivable. It is in these ways that adequate level of working capital is absolutely necessary for smooth sales activity which, in the owner's wealth.

The last phase, phase III, represents the stage when receivables are collected, This phase completes the operating cycle. Thus, the firm has moved from cash to inventory, to receivables and to cash again.

Posted by: andy

Share This