Optimal Investment in Current Assets, Essay Example
Competition these days is fierce, and opportunities for growth must be identified and implemented. For a company that operates a wholesale materials and supply business that caters to both residential and commercial customers, you must take note of your competitors and attempt to grow your market share. The task presented here is to come up with a solution that will grow this company’s business by ten percent within two years, and a key element of that growth will be to determine the optimal investment of your company assets to help achieve this goal in the most effective manner.
Why is it so important to identify the optimal investment of company assets? As one article describes it, “Asset allocation is a fundamental investing principle, because it helps investors maximize profits while minimizing risk (Investopedia, 2009)”. If this optimal level is not achieved, a firm may risk excessive investment, which may lead to lack of funds to invest in other worthwhile efforts. On the opposite side of this is too little investment can lead to a lack of profitability because the resources that are available are not being used. Either situation is not ideal, and optimal investment avoids both problems. As one article describes, “Finding the right level of investment requires a trade off between minimizing cost without hindering the liquidity of business (Baker and Powell, 2005)”.
There are choices the company can make under a short-term financial policy that is flexible with regard to current assets. One description of their characteristics include keeping large quantities of cash and marketable securities, significant investments in inventory, and offering liberal credit availability (Emanuela and Craciun, 2008). If this company plans on growing their business by ten percent, maintaining a higher inventory of goods would be wise in order to accommodate increased demand. In addition, offering more liberal credit terms with longer payback or easier qualifications could assist in obtaining more purchasers. We know that our main competitor that is located nearby does ninety percent of their sales on a credit basis. There are different ways our company can grow, but one way may be to take their customers, and their customers clearly prefer to buy with credit.
Our company could also choose to pursue a restrictive short-term financial policy for their current assets. As similarly cited for flexible short-term policies, characteristics for this policy would include maintaining reduced cash balances, lack of investment in marketable securities, keeping inventory investment low, and avoiding credit sales (Emanuela and Craciun, 2008). When you consider that any effort to grow rapidly will require more product inventory, and that our competitor does ninety percent of their sales by credit, this may be a difficult short-term financial policy to follow. The company would have to be in a position where they could increase inventories quickly if demand increased, and they would also have to find a way to increase their customers without offering more credit, which means customers of the competition may not be likely customers for our company.
Closely related to short-term financial policies that involve the company’s assets are costs that increase with a rise in investment levels. These are called carrying costs, and these costs have main components such as interest expenses, insurance, taxes, and expenses in handling of goods, damage and age of product (Baker and Powell, 2005). Carrying costs also exhibit certain behaviors based on investment levels. For example, maintaining high levels of inventory will generally increase these costs, as there is a cost associated with maintaining the value of the inventory (Emanuela and Craciun, 2008).
Another cost associated with short-term financial policies are costs that increase with a low investment of current assets. These are called shortage costs, and these costs have main components such as out of stock costs, losses due to lack of supply, and potential lack of goodwill from customers as a result of supply shortages (Baker and Powell, 2005). Like carrying costs, shortage costs also have certain behaviors based on investment levels. For example, a shortage cost will decrease when inventory levels are increased (Emanuela and Craciun, 2008).
The general steps used to determine the optimal investment in current assets for our company would need to follow the priorities that are in place. As the company’s stated goal is to grow by ten percent within a two year period, the company must invest in flexible short-term financial policies for current assets to a level that can accommodate this growth. However, they must be careful not to over-invest, as if there policies do not exhibit enough restrictive characteristics they may invest too excessively and fail to minimize their risk. As the company sets out to grow its business, it is important that they monitor their carrying costs and shortage costs carefully. If their carrying costs are low and shortage costs are high then the company can deduce that their financial policy is too restrictive, and they need to invest more in inventories, more lenient credit terms, or other flexible short-term financial policies. On the other hand, if carrying costs are high and shortage costs are low, the company’s policies are too flexible, and they will need to address by applying more restrictive policies such as lower inventories and offering less or even no credit. Through balancing these different sets of short-term financial policies and costs, our company should be able to achieve its goals.
Baker, H. K. and Powell, G. E. (2005). Understanding Financial Management: a practical guide. Oxford, U.K. Blackwell Publishing.
Emanuela, D. A. and Crucian, S. (2008). Short-Term Financial Planning for Small and Medium Sized Enterprises. Confcontact.com. Retrieved from <http://confcontact.com/articles/domil.pdf>
Investopedia. (2009). Achieving Optimal Asset Allocation [online article]. Retrieved from <http://www.investopedia.com/articles/pf/05/061505.asp#axzz1xpYEIa3x>
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