The need for working capital to run the day-to-day business activities cannot be overemphasized. We will hardly find a business firm which does not require any amount of working capital, indeed firms differ in their requirements of the working capital.
We know that a firm should aim at maximizing the wealth of its shareholders. In its endeavour to do so, a firm should earn sufficient return from its operations. Earnings a steady amount of profit requires successful sales activity. The firm has to invest enough funds in current assets for generating sales. Current assets are needed because sales do not convert into cash instantaneously. There is always an operating cycle involved in the conversion of sales into cash.
There is a difference between current and fixed assets in terms of their liquidity. A firm requires many years to recover the initial investment in fixed assets such as plant and machinery or land and buildings. On the contrary, investment in current assets such as inventories and debtors (accounts receivable) is realized during the firm’s operating cycle that is usually less than a year what is an operating cycle?
Operating cycle is the time duration required to convert sales, after the conversion of resources inventories, into cash. The operating cycle of a manufacturing company involves three phases:
1. Acquisition of resources such as raw material, labour power and fuel etc.
2. Manufacture of the product which includes conversion of raw material into work-in-progress into finished goods.
3. Sale of the product either for cash or on credit. Credit sales create account receivable for collection.