Investment in Current Assets
Optimal investment in current asset is part of the working capital management policy within an organization. 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 shall 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’s decision of selecting a short-term investment policy must be based upon maximizing the firm value in the long run while keeping a balance between the profitability and liquidity goals of the company.
Growth companies 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 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 might select an aggressive short-term financing policy whereby 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 a company short-term financing policy were restrictive, 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 any short-term interest rate fluctuations.
On one hand, companies carrying cost components such as; interest expenses, insurance & taxes, material handling expenses, damage and obsolescence cost will increase with the increase in inventory investment. On the other hand, its shortage cost components such as; stock out cost, lost contribution due to shortage of supply and customer goodwill foregone will decrease with the increase in investment in inventory you hold.
