Define the purpose of working capital?

Question

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.

Answer 1

Current assets- current liabilities = Working capital.
So if you give credit and don't get same time for repayment for the credit you get then the cash coversion cycle prlongs which will affect your working capital.
Similarly inventory can raise your working capital. Inventory has both reorder cost and carrying costs. So you have to optimise on this to get the optimal inventory at all times. It is called Economic Reorder Quantiy. Just in time inventories by the Japanese also reduce inventory costs and less cash conversion cycle and low working capital costs.
Let me enhance the answer by giving you the EOQ equation which teaches you how Working capital is optimise.
Let,
d be annual demand
Q the economic batch
quantity
c reorder cost of each item
i the carrying cost of each ite
as a percentage of cost/item
Then,
Carrying cost= ipQ/2
reorder cost=cd/Q
Total cost(tc)= ipQ/2+
cd/Q
d tc/dQ=ip/2-cd/Q^2
there for,
Q=Squ. root. 2cd/ip.
This much reorder quantity or batch size will keep the inventory cost down and working capital at optimised levels without hurting business.