Study unit 8 Asset management: the investment decision Flashcards
Why Over-investment in current assets is costly
Because the capital tied up in current assets could be invested profitably elsewhere.
Why is under-investment is risky
Because if there is an unforeseen delay somewhere along the line, there might be a serious delay in the factory (which is very costly), or the customer will buy the product elsewhere.
You must understand the three basic reasons (motives) for having a certain amount of cash on hand.
x
What can a business do to shorten its cash cycle?
One way is to reduce the amount owing to it by debtors. This is because the greater the amount of money that is owed by debtors, the greater the likelihood of bad debts (ie debts not paid by debtors) – and therefore the more capital that is tied up in debtors.
How can a business reduce the number of debtors
A business can grant less credit to customers, tighten up on the credit terms, and/or enforce the collection policy more strictly. The firm could also offer discounts for prompt settlement of accounts.
The risks to reducing the amount invested in debtors.
If the business grants less credit (eg by refusing to grant credit to anyone who does not have an exceptionally high credit rating) it may well lose sales. If it tightens up on its credit terms (eg demand- ing settlement of accounts within a shorter period) it may also drive some customers into the arms of a competitor who has a more lenient credit policy. If it enforces the collection policy more strictly (eg taking customers to court if they do not settle their debts within the specified period) it may also frighten off potential customers.
Another way to shorten the cash cycle is:
To reduce the level of inventory, be it raw mate- rials or finished goods. Again this requires maintaining a fine balance between keeping inventory costs at a minimum and at the same time keeping the loss of sales or delays in production (as a result of unavailable stock) to a minimum.
The first aspect of capital investments
The magnitude. Many of these capital projects require large sums of money, and if the wrong decision is made this may have a serious effect on the business’s profitability, and may even lead to the bankruptcy of a business.
An investment in a capital project is risky,
in terms of the large sums of money involved, but is even more risky because of the long-term nature of such a project.
The net cash flow
The net cash flow is simply the difference between the amount of money that flowed into the business (by way of sales, investment income, etc) and the amount of money that flowed out of the business (cost of materials, wages, interest, taxes, etc).
