Why do firms need to invest in net working capital?

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Why do firms need to invest in net working capital?



Answer: - Short-term financial planning is concerned with the management of the firm's short-term, or current, assets and liabilities. The most important current assets are cash, marketable securities, inventory, and trade receivables. The most important current liabilities are bank loans and trade payables.
- The difference between current assets and current liabilities is called NET WORKING CAPITAL (NWC). NWC arises from lags between the time the firm obtains the raw materials for its product and the time it finally collects its bills from customers. The OPERATING CYCLE is the length of time from the purchase of raw materials to the collection of cash from customers.
- The cash CONVERSION CYCLE is the length of time between the firm's payment for materials and the date that it gets paid by its customers. THE CASH CONVERSION CYCLE is partly within management's control. For example, it can choose to have a higher or lower level of inventories.
- Management needs to trade off the benefits and costs of investing in current assets. Higher investments in current assets entail higher CARRYING COSTS but lower expected SHORTAGE COSTS.

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