Financial Management
Module 4
Investment Decision
Investment decision refers to the decisions that involve the investment of various resources of the
firm to gain the highest possible return on investment for their investors. An investment decision
is categorized as a long-term and short-term investment decision.
Financial Management is concerned with the management of the flow of funds and involves
decisions related to the acquisition and application of funds in long-term and short-term assets. It
is concerned with two aspects, they are procurement of funds as well as usage of finance. There
are three major decisions that every financial management takes: Investment Decision, Financial
Decision, and Dividend Decision.
Investment decision refers to the decisions that involve the investment of various resources of
the firm to gain the highest possible return on investment for their investors. An investment
decision is categorized as a long-term and short-term investment decision. A firm has to also
keep in mind the scarcity of resources. It involves carrying out financial decisions on a long-term
basis. This type of investment is known as a Capital Budgeting Decision.
For example, investing in a new machine to replace an existing one or getting a new fixed asset
or opening a new branch, etc. Such decisions are extremely important for any organization as
they control the decisions regarding its earning capacity in the long run.
The size of assets, profitability, and competitiveness are all influenced by investment decisions.
These decisions generally involve vast amounts of investment and are mostly irreversible except
when there is a huge cost. Therefore, once the decisions are made, it is almost impossible for a
business to avoid such decisions, and they need to be managed with extreme caution. Such
decisions should be taken by some who is thorough with the organization and its work. A poor
capital budgeting decision has the power to seriously damage the financial fortune of any
business. The everyday working of a business is affected by such decisions. They also influence
the liquidity and the probability of a business. The necessary elements of sound working capital
management include Efficient cash management, inventory management, and receivables
management.
A short-term investment decision is known as a Working Capital Decision. Such decisions
involve decisions regarding the levels of cash, inventory, and receivables. Short-term decisions
are required in the everyday working of a business and also influence the liquidity as well as the
profitability of a business. The essential elements of sound working capital management are
efficient cash management, inventory management, and receivables management. There are
several projects available for the firm to invest in. The projects have to be analyzed cautiously
and are selected or rejected based on the volume of return.
Working Capital Management
Working capital management is a business strategy designed to manage a company's working
capital. A company's working capital refers to the capital it has left over after accounting for its
current liabilities. Working capital management ensures that a company operates efficiently by
monitoring and using its current assets and liabilities to their most effective use. The efficiency
of working capital management can be quantified using ratio analysis.
Working capital management requires monitoring a company's assets and liabilities to maintain
sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
Managing working capital primarily revolves around managing accounts receivable, accounts
payable, inventory, and cash. Working capital management involves tracking various ratios,
including the working capital ratio, the collection ratio, and the inventory ratio. It can improve a
company's cash flow management and earnings quality by using its resources efficiently.
Working capital management strategies may not materialize due to market fluctuations or may
sacrifice long-term successes for short-term benefits.
Working Capital Management Components
1. Cash
The core of working capital management is tracking cash and cash needs. This involves
managing the company's cash flow by forecasting needs, monitoring cash balances, and
optimizing cash flows (inflows and outflows) to ensure that the company has enough cash to
meet its obligations. Because cash is always considered a current asset, all accounts should be
considered. However, companies should be mindful of restricted or time-bound deposits.
2. Receivables
To manage capital, companies must be mindful of their receivables. This is especially important
in the short term as they wait for credit sales to be completed. This involves:
● Managing the company's credit policies
● Monitoring customer payments
● Improving collection practices
At the end of the day, having completed a sale does not matter if the company is unable to collect
payment on the sale.
3. Accounts Payable
Accounts payable refers to one aspect of working capital management that companies can take
advantage of that they often have greater control over. While other aspects of working capital
management may be uncontrollable, such as selling goods or collecting receivables, companies
often have a say in how they pay suppliers, what the credit terms are, and when cash outlays are
made.
4. Inventory
Companies primarily consider inventory during working capital management as it may be the
most risky aspect of managing capital. When inventory is sold, a company must go to the market
and rely on consumer preferences to convert inventory to cash.
If this cannot be completed quickly, the company may be forced to have its short-term resources
stuck in an illiquid position. Alternatively, the company may be able to quickly sell the inventory
but only with a steep price discount.
Types of Working Capital
In its simplest form, working capital is the difference between current assets and current
liabilities.
Permanent working capital: Permanent working capital is the amount of resources the
company will always need to operate its business without interruption. This is the minimum
amount of short-term resources vital to a company's operations.
Regular working capital: Regular working capital is a component of permanent working
capital. It is the part of the permanent working capital that is required for day-to-day operations
and makes up the most important part of permanent working capital.
Reserve working capital: Reserve working capital is the other component of permanent
working capital. Companies may require an additional amount of working capital on hand for
emergencies, seasonality, or unpredictable events.
Fluctuating working capital: Companies may be interested in only knowing what their variable
working capital is. For example, companies may opt to pay for inventory as it is a variable cost.
However, the company may have a monthly liability relating to insurance it does not have the
option to decline. Fluctuating working capital only considers the variable liabilities the company
has complete control over.
Gross working capital: Gross working capital is simply the total amount of current assets of a
business before considering any short-term liabilities.
● Net working capital: Net working capital is the difference between current assets and
current liabilities.
Importance of Working Capital management in success of firm
Proper working capital management is essential for businesses to be successful and avoid the risk
of overcapitalization. In today's ever-changing business environment, it is vital to have a clear
and concise understanding of working capital management and its impact on the overall
performance of the business. Working capital management is not only about maintaining
sufficient cash flow, but it also involves managing the company's short-term assets and
liabilities. The goal is to ensure that the business has enough liquidity to meet its short-term
obligations while still having enough capital to invest in future growth opportunities.
1. Improved Cash Flow: Effective working capital management ensures that a company has
enough cash on hand to meet its short-term obligations. By managing accounts receivable and
accounts payable, companies can better manage their cash flow, which helps them to avoid cash
shortages.
2. Enhanced Profitability: Proper working capital management can help a business increase its
profitability. By optimizing inventory levels, reducing the number of days outstanding for
receivables, and extending the payment period for payables, a company can reduce its operating
costs and improve its profitability.
3. Mitigating Risk: Effective working capital management helps mitigate the risk of
overcapitalization. Overcapitalization occurs when a company has more capital than it can
effectively use. This can lead to inefficient use of resources and a reduction in profitability. By
managing working capital effectively, companies can avoid the risk of overcapitalization and
ensure that their capital is being utilized efficiently.
4. Improved Business Relationships: Effective working capital management can help improve
relationships with suppliers and customers. By paying suppliers on time and managing accounts
receivable, companies can build trust and improve their reputation.
Effective working capital management can lead to improved cash flow, enhanced profitability,
and mitigating the risk of overcapitalization. Companies that prioritize working capital
management can improve their business relationships, reduce their operating costs, and increase
their profitability.
Determinants of working capital
1. Nature of Business
The first factor which helps in determining the requirement of working capital is the type of
business in which the company is involved. A trading company or a retail shop requires less
working capital as the length of the operating cycle of these types of businesses is small.
However, the wholesalers require more working capital, as they have to maintain a large stock
and generally sell goods on credit, increasing the length of the operating cycle. Besides, a
manufacturing company requires a huge amount of working capital as it has to convert its raw
materials into finished goods, sell the goods on credit, and maintain the inventory of raw
materials and finished goods.
2. Scale of Operation
The firms that are operating at a large scale need to maintain more debtors, inventory, etc. Hence,
these firms generally require a large amount of working capital. However, the firms that are
operating at a small scale require less working capital.
3. Business Cycle Fluctuation
A market flourishes during the boom period which results in more demand, more stock, more
debtors, more production, etc., ultimately leading to the requirement for more working capital.
However, the depression period results in less demand, less stock, fewer debtors, less production,
etc., which means that less working capital is required.
4. Technology and Production Cycle
A company using labor-intensive techniques requires more working capital because it has to
maintain enough cash flow for making payments to labor. However, a company using
capital-intensive techniques requires less working capital because the investment made by the
company in machinery is a fixed capital requirement, and also there will be less operating
expenses.
10. Level of Competition
If there is competition in the market, then the company will have to follow a liberal credit policy
for supplying goods on time. For this, it will have to maintain higher inventories, resulting in
more working capital requirements. However, if there is less competition in the market or a
company is in a monopoly position, then it will require less working capital, as it can dictate its
own terms according to its requirements.
11. Inflation
A rise in the price increases the price of raw materials and the cost of labour, resulting in the
increasing requirement for working capital. However, if a company is able to increase the price
of its goods also, then it will face less problem with working capital. A rise in price has a
different effect on the working capital of different businesses.
8. Operating Efficiency
If a company has a high degree of operating efficiency then it will require less working capital;
however, if a company has a low degree of operating efficiency then it will require more working
capital. (Operating cycle of a firm is the time period from the purchase of raw material to the
realisation from debtors). Hence, it can be said that the length of the operating cycle directly
affects the requirements of the working capital of an organisation.
9. Availability of Raw Materials
If the raw material is easily available to the firm and there is a ready supply of inputs and raw
material, then the firm can easily manage with less working capital. Also, as the firm does not
need to maintain any stock of raw materials, they can manage with less stock, and hence less
working capital. However, if there is a rough supply of raw materials, then the firm will have to
maintain a large inventory to carry on the operating cycle smoothly. Therefore, the firm will
require more working capital.
Capital Budgeting?
Capital budgeting is a process that businesses use to evaluate potential major projects or
investments. Building a new plant or taking a large stake in an outside venture are examples of
initiatives that typically require capital budgeting before they are approved or rejected by
management. As part of capital budgeting, a company might assess a prospective project's
lifetime cash inflows and outflows to determine whether the potential returns it would generate
meet a sufficient target benchmark. The capital budgeting process is also known as investment
appraisal.
● Capital budgeting is used by companies to evaluate major projects and investments, such
as new plants or equipment.
● The process involves analyzing a project's cash inflows and outflows to determine
whether the expected return meets a set benchmark.
● The major methods of capital budgeting include discounted cash flow, payback analysis,
and throughput analysis.
Discounted Cash Flow Analysis
Discounted cash flow (DCF) analysis looks at the initial cash outflow needed to fund a project,
the mix of cash inflows in the form of revenue, and other future outflows in the form of
maintenance and other costs.
These cash flows, except for the initial outflow, are discounted back to the present date. The
resulting number from the DCF analysis is the net present value (NPV). The cash flows are
discounted since present value assumes that a particular amount of money today is worth more
than the same amount in the future, due to inflation.
Payback Analysis
Payback analysis is the simplest form of capital budgeting analysis, but it's also the least
accurate. Payback analysis calculates how long it will take to recoup the costs of an investment.
The payback period is identified by dividing the initial investment in the project by the average
yearly cash inflow that the project will generate. For example, if it costs $400,000 for the initial
cash outlay, and the project generates $100,000 per year in revenue, it will take four years to
recoup the investment.
Payback analysis is usually used when companies have only a limited amount of funds (or
liquidity) to invest in a project, and therefore need to know how quickly they can get back their
investment.
Throughput Analysis
Throughput analysis is the most complicated method of capital budgeting analysis, but it's also
the most accurate in helping managers decide which projects to pursue. Under this method, the
entire company is considered as a single profit-generating system. Throughput is measured as the
amount of material passing through that system. The analysis assumes that nearly all costs are
operating expenses, that a company needs to maximize the throughput of the entire system to pay
for expenses, and that the way to maximize profits is to maximize the throughput passing
through a bottleneck operation.
Nature of Investment Decisions
1. Require Huge Funds: Investment decisions require a large amount of funds to
be deployed by firms for earning profits. These decisions are very imperative
and require due attention as firms have limited funds but the demand for the
funds is excessive. Every firm should necessarily plan its investment
programmes and control its expenditures.
2. High Degree of Risk: These decisions involve a high amount of risk as they are
taken on the basis of estimated return. Large funds are invested for earning
income in the future which is totally uncertain. These returns fluctuate with the
changes in fashion, taste, research and technological advancement thereby
leading to a greater risk.
3. Long Term Effect: Investment decisions have a long lasting effect on future
profitability and growth of a firm. These decisions decide the position of a firm
in future. Any wrong decision may have very adverse effects on the return of an
organization and may even endanger its survival. Whereas, the right decision
taken brings good returns for firms leading to better growth.
4. Irreversibility: Decisions related to investment are mostly irreversible in
nature. It is quite difficult to revert back from decisions once taken related to the
acquisition of permanent assets. Disposing off these high value assets will cause
heavy losses to firms.
5. Impacts Cost Structure: Investment decisions widely impact the cost structure
of an organization. Firms by taking these decisions commit themselves to
various fixed costs such as interest, rent, insurance, supervision etc. for the sake
of earning profits. If these investments do not provide the anticipated return,
then firm overall cost will rise thereby causing losses.
6. Long term Commitment of Funds: Funds are deployed for a longer term by
organizations through these decisions. Firm deployed a high amount of capital
for a long period on a permanent basis. Financial risk in investment decisions
increases due to long term commitment of funds. A firm should properly plan
and monitor all of its capital expenditures.
7. Complexity: Investment decisions are most complex decisions as they are
based on future events which are totally uncertain. Future cash flows of an
investment cannot be estimated accurately as they are influenced by changes in
economic, social, political and technological factors. Therefore, uncertainty of
future conditions makes it difficult to accurately predict the future returns.