6.9 Inventory and cash management

Western Sydney University **We aren't endorsed by this school
MATH 200910
Oct 20, 2023
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Inventory and cash management INVENTORY MANAGEMENT - The role of the inventory manager is to balance the costs and benefits associated with inventory. Because excessive inventory uses cash, efficient management of inventory increases firm value. BENEFITS OF HOLDING INVENTORY - Inventory helps minimise the risk that the firm will not be able to obtain an input it needs for production and helps avoid stock-outs, where the firm lacks sufficient inventory. - Factors such as seasonality of demand mean that customer purchases do not perfectly match the most efficient production cycle COSTS OF HOLDING INVENTORY The following are the different costs of holding inventory: Acquisition costs are the costs of the inventory itself over the period being analysed (usually one year). Order costs are the total costs of placing an order over the period being analysed. Carrying costs include storage costs, insurance, taxes, spoilage, obsolescence and the opportunity cost of the funds tied up in the inventory. Minimising these total costs involves some trade-offs. For example, the lower the level of inventory a firm carries, the lower its carrying cost, but the higher its annual order costs because it needs to place more orders during the year. Some firms seek to reduce their carrying costs as much as possible. With 'just-in-time' (JIT) inventory management, a firm acquires inventory precisely when needed so that its inventory balance is always zero, or very close to it. CASH MANAGEMENT - In the real world, liquidity has a cost. For example, holding liquid assets may earn a below-market return, and a firm may face transaction costs if it needs to raise cash quickly. In these cases, the optimal strategy for a firm is to hold cash in anticipation of seasonalities in demand for its products and random shocks that affect its business. Risky firms and firms with high-growth opportunities tend to hold a relatively high percentage of assets as cash. Firms with easy access to capital markets (for which the transaction costs of accessing cash are therefore lower) tend to hold less cash.
MOTIVATION FOR HOLDING CASH There are several motivations for holding cash. They can include: Transactions balanc e: To meet day-to-day needs. Precautionary balance : To compensate for the uncertainty associated with its cash flows. Compensating balance : An amount a firm's bank may require the firm to maintain in an account at the bank as compensation for services the bank may perform. ALTERNATIVE INVESTMENTS - In our discussion of collection and disbursement floats, we assumed that the firm will invest any cash in short-term securities. In fact, the firm may choose from a variety of short-term securities that differ somewhat with regard to their default risk and liquidity risk. The greater the risk, the higher the expected return on the investment. The financial manager must decide how much risk he or she is willing to accept in return for a higher yield. - A financial manager who wants to invest the firm's funds in the least risky security will choose to invest in Treasury notes. However, if the financial manager wishes to earn a higher return on the firm's short-term investments, he or she may need to invest some or all of the firm's excess cash in a riskier alternative, such as promissory notes issued by companies.
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