Download Optimal investment in current asset is part of the

Optimal investment in current asset is part of the working capital
management policy within an organization. Gross working capital is the
investment in current assets while net working capital is current assets
less current liabilities. An effective working capital management requires
right amount of investment in current assets and appropriate level of
short term financing. Excessive investment in current assets means lack
of funds to invest elsewhere which will effect the liquidity aspect of the
company, while too little investment means inability to service the
growing demand for the goods which will erode the profitability of the
company.
Therefore, it is a matter or finding that equilibrium or optimal level of
investment in current asset and a right mix of financing (either short term
or long term) to support the investment. Company A's decision of
selecting a short term investment policy with regards to current asset
must be based upon maximising the firm value in the long run while
keeping a balance between the profitability and liquidity goals of the
company.
Growth companies like the one presented here should focus on keeping
stock of inventory to service the predicted growth in demand as well as to
compete with the local wholesalers. Although the investment in current
asset will not provide better return as compared to long term investment
options, however, the opportunity cost of a sale foregone due to
unavailability of stock can keep the company out of business forever.
Hence finding the right level of investment requires a trade off between
minimizing cost without hindering the liquidity of business.
Company A's might select an aggressive short term financing policy that is
flexible with regards to current asset. It will fund both its temporary and
permanent current assets with the help of short term finance, if the
demand of goods fluctuate and access of short term finance is readily
available. Manager's prediction about the movement in short term interest
rate as compared to long term interest rate will also affect the decision.
However, if company A short term financing policy is restrictive with
regards to current asset, it would be better off with a conservative action
by funding permanent current asset and part of temporary current assets
with long term finance. By taking this approach company can lock in the
cost of funds and avoid and short term interest rate fluctuations.
Main components of carrying costs are interest expenses, insurance &
taxes, material handling expenses, damage and obsolescence. All the
above mentioned components of the carrying cost will increase with the
increase in the amount of investment in inventory you hold.
Main components of shortage costs are stock out cost, lost contribution
due to shortage of supply and customer goodwill foregone. All the above
mentioned components of the shortage cost will decrease with the
increase in the amount of investment in inventory you hold.
Reference:
1. Harold Kent Baker, Gary E. Powell, “Understanding Financial
Management: a practical guide” Blackwell publishing, 2005