Current assets investment should comprise the best possible combinations of cash, debtors, inventory, and prepayments. The study and analysis of the composition and nature of working capital can also be referred to as the study of the elements of the current assets structure, and is an important issue that is worthy of consideration (Maness, 1994).
3.4.1 CASH AND MARKETABLE SECURITIES
Cash and short-term securities are the most liquid current assets, are readily available for use and are required to meet the firm’s daily obligations. Keynes (1936) identified three motives for holding cash; the transaction motive (making planned expenditure), the precautionary motive
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(protecting the business against emergency cash demands) and the speculative motive (holding cash in order to take advantage of specials on raw materials and favourable interest rates and foreign exchange movements). The need to satisfy financial agreements (the contractual motive) has also been identified as one of the motives for holding cash.
Prudential cash management means that the firm keeps sufficient cash on hand to pay for miscellaneous over-the-counter transactions and petty disbursements and invests the remainder in securities which are highly marketable and liquid (Nwankwo and Osho, 2010). The consequences of inadequate cash and liquid resources are severe and far-reaching; liquidity crisis, failure to pay maturing short-term obligations, increasing the risk of insolvency and difficulties in surviving (Chakraborty, 2008). On the other hand, excessive cash holdings compromise returns because cash is a non-earning asset while marketable securities earn low returns on the market. Excessive cash holdings are a sign that a firm has idle funds and such a firm is incurring a cost on such funds because it is difficult to earn a return higher than the cost of funds on current assets (Sagner, 2007). The conflicting consequences of excessive cash holdings and cash shortages mean that the firm must maintain an optimum cash balance that enables it to pay its debts as and when they mature, while ensuring that it does not hold excessive cash levels.
3.4.2 ACCOUNTS RECEIVABLE (TRADE DEBTORS)
Accounts receivable are generated when the firm sells its goods or services on credit2 (supplying goods/services to customers before payment). Although cash sales are attractive because they allow the firm to minimise the funds locked-up in receivables and eliminate the need to finance receivables, a cash sales policy is costly and impractical. Accounts receivable management involves decisions about and the implementation of firm’s credit policy such as
2Most firms demand and extend trade credit simultaneously. A deeper discussion on the motives for trade credit is provided in the section on trade credit as a working capital financing instrument.
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who the firm should grant credit to, credit limits, length of the credit period, cash discounts and penalties for late payment.
Granting credit to customers has benefits and costs. Credit sales can stimulate sales, help the firm capture market share, ward off competition and enable the firm to charge a higher price, thereby increasing both the profit margin and sales in the short-term (Nadiri, 1969, Smith, 1987, Schwartz, 1974). Credit sales may help the firm maintain consistent sales levels over time because customers purchasing goods and services for cash tend to buy goods when they have cash available, which may result in erratic and perhaps cyclical purchasing patterns. Credit sales help the firm to increase near-term sales and eliminate the need for customers to build up enough cash to purchase goods/services. The extension of trade credit effectively shifts future sales closer to the present time. Granting credit to customers has costs. When credit is extended, the firm must finance the inventory; there is an opportunity cost of funds tied-up in debtors, the risk of non-payment by some customers and the cost of running a credit department (Gitman, 1997, Firer et al., 2012). The benefits and costs of selling goods on credit imply that there exists an optimum point where the benefits of extending credit are offset by the cost of extending credit.
3.4.3 INVENTORY (STOCK)
Inventory is the firm’s investment in raw materials, work-in-progress, and finished goods or those held for resale. Raw materials are materials held in their original state for processing and production. Work-in-progress is raw materials which have been partly processed, altering their original state, shape, size or other properties. Finished goods have been completely processed and are ready for sale. Inventory represents the most illiquid yet the most significant component of the firm’s current assets (Nwankwo and Osho, 2010) and its management significantly affects both firm liquidity and profitability. Inventory management has two main objectives; lowering the idle-time cost of labour and machinery due to stock-outs of raw materials and reducing inventory ordering and carrying costs, funds tied up in inventories and losses due to obsolescence. Like cash holdings and receivables, inventory holdings there are
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benefits and costs of holding too much and too little inventory. Holding high inventory levels enables the firm to run smooth and uninterrupted production schedules and meet any unanticipated increases in sales demand. On the other hand, holding inventory incurs carrying costs and has an opportunity cost of having funds tied-up in non-income-earning assets because such funds could be invested in other profitable investments (Gitman et al., 2010).
A number of inventory management techniques have been used to achieve the goal of minimising total inventory costs. Inventory management techniques include the ABC approach, the Economic Order Quantity (EOQ) model, Material Resource Planning (MRP), Just-In-Time (JIT) and Enterprise Resource Planning (ERP).