Optimal investment in current asset is part of the working ...



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

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