Page 271 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes goods) and (3) finished goods. The raw material inventories certain items that are purchased by
the firm from others and are converted into finished product through manufacturing (production)
process. They are an important impact of the final product. The work in progress is normally,
partially or semi-finished goods, at the various stages of production in a multi-stage production
process. Finished goods represent final or completed products, which are available for sale. The
inventory of such goods consists of items that have been produced but are yet to be sold.
Inventory, as a current asset, differs from other current assets because it is not finance managers
who alone are involved here. Rather, all the functional areas in finance, marketing, production
and purchasing are involved.

12.1 Role of Inventory in Working Capital

Inventories are components of the firm’s working capital and as such represent current asset.
Some characteristics that are important in the broad context of working capital management
include:

1. Current asset: It is assumed that inventories will be converted into cash in the current
accounting cycle, which is usually one year. There are exceptions to this e.g., wine may be
kept in casks or bottles for many years for the proper formation of the product. A
manufacturer of fine pianos may have a production process that exceeds one year.
2. Level of liquidity: Inventories are considered as a source of near cash for more of the
products. Some firms at some time may hold some slow moving items that may not be
sold for a long time. With chronic slowdown or changes in the markets for goods the
prospects for sale of entire product lines may be diminished. In these cases, the liquidity
aspects of the inventories become important to the manager of working capital. Firms
must keep a reasonable margin for uncertain operating environments, the analysis must
discount the liquidity value of the inventories significantly.

3. Liquidity Lag: Inventories are tied to the firm’s pool of working capital through three
specific lags, namely:

(a) Creation lag: In majority of cases, inventories are purchased on credit, creating an
account payable, when the raw materials are processed in the factory, cash is paid
for production expenses for the requirement during the period, labour is paid on
pay day, utility bill for electricity is paid after the bill is submitted, Or for goods
purchased for resale, the firm may have 30 or more days to hold the goods before
payment is due.
(b) Storage lag: Once goods are available for sale, they will not be immediately converted
into cash by sealing even when sales are moving fast, the firm will hold inventory
as a back up. Thus the firm will usually pay suppliers, workers, utility and other
overhead expenses before the goods are actually sold. This lag represents a cost to
the firm.
(c) Sale lag: Once goods have been sold, they normally do not create cash immediately.
Most sales occur in credit and accounts receivable is created. The firm has to wait to
collect receivables. This lag also represents a cost to the firm.
4. Circulating activity: Inventories get rotated with other current assets. They get converted
into cash and then invested again in inventory to continue the operating cycle.

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