Working capital management is one of the important areas of financial planning and control. Inventories and accounts receivables are the two important components of current assets. On average, inventories cover one third of the value of total assets in a balance sheet. Similarly, receivables from customers are another important element.
The present study identifies the determinants of closing inventories, and tests the hypothesis of inverse relation between trade debtors and closing inventories. Because firm usually faces liquidity problem during recessions and has excess inventories at the beginning of a contractionary period, the study also examines the business cycle's point of view. It tests the hypothesis that a firm can sell its excess inventories if it can afford to increase its receivables, which may protect a firm from the risk of price shocks and improve its profitability.
The author presents a model based on 3,375 observations from industrial firms in Pakistan and the three-stage least square (3SLS) technique is applied for the estimation. The estimates suggest the follwing:
on average, five percent of sales revenues are attributable to accounts receivable, which confirms the hypothesized direct relation between sales and a credit facility
accounts receivable are a substitute for closing inventories
many factors that can change the volume of inventories and the Economic Order Quantity (EOQ) including the extent of material usage, the acquisition cost of material, the managerial and storage cost of inventories and the opportunity cost of investment in inventories
The author concludes that that a soft credit policy will not improve the solvency position of a firm. It may cause an improvement in sales revenue (and possibly in net profit), but not in working capital. He suggests that a firm can increase its receivables by generating a sufficient amount of reserve funds through retained earnings or by obtaining short-term credit facilities.