Page 205 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Assuming no additional capital is invested for this purchase, the portion of net earnings of
business needed to maintain the inventory required for continuing operations during a period
of rising X costs can be expressed as a formula. If
I - Cost of inventory at the beginning of the year
T - Turnover rate for the inventory investment
R - Rate of earnings stated as the percentage which the net income after tax is of the total
cost of goods for the year.
Net Earnings = (I)(T)(R)
If ‘i’ is the percentage increase in the replacement cost of inventory and ‘e’ represents the fraction
of the year’s earnings needed to maintain same physical volume of inventory. Then
iI = e.I.T.R
e = i/TR

Income tax rates are significant in the analysis of the consequence of increases in inventory cost
because of their effect on the amount of net earnings. Every increase in income tax rate cause a
reduction in the rate of earnings and results in a larger portion of the net earnings being
required to maintain the inventory during a period of rising costs.
Costing an inventory by references to LIFO assumption to the flow of the costs will not alter the
amount required to maintain or the intrinsic value of the inventory, but its use will tend to keep
the increase in cost out of the computed income from operations. Also, any reduction in the
amount of income taxes payable by a business will result in more case being available to
maintain the inventory and for other needs of the enterprise.

Example: Taking the same example as in the Average Cost and FIFO method, if one item
were sold for ` 250 using the LIFO method, the cost of goods sold would be ` 140, profit would
be ` 110 (` 250 – `140), and ending inventory balance would be ` 350 (` 100 + ` 120 + `130).

Self Assessment

Fill in the blanks:

9. The ....................... process is greatly simplified if electronics data-processing equipment is
available.
10. Other things being equal, the optimal safety stock ....................... as the cost of stock outs
increases.

12.4 Inventory Management and Cash Flow Timeline

Cash Flow Timeline can be defined as a line or chart showing a company’s cash inflows and cash
outflows and the business activities that caused them over a given period of time.
From the financial manager’s point of view, inventory represents an idle investment of corporate
resources. If the inventory is purchased with cash, there is an opportunity cost of the funds
expended. If inventory is purchased on credit, the firm incurs additional debt and its unused
borrowing capacity is diminished.

Suppose a firm requires a total of 90,000 units of inventory for a production run. Further, assume
that two orders for inventory are placed for 4,000 units each. Inventory would be paid for with
cash and ordering and holding costs would be paid at the end of the production run.

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