Question

Why might an organization maintain more than necessary amounts of cash, accounts receivable, and inventory? Why might another organization maintain the minimum amount of cash, accounts receivable, and inventory? What would be the difference in risk and return for these companies?

Answer 1

The amount of cash, accounts receivable, and inventory a firm maintains depends on its working capital policy. A working capital policy refers to the level of investment in current assets for attaining targeted sales.

So when an organization maintains more than necessary amounts of cash, accounts receivable and inventory it is said to have a relaxed or conservative working capital policy. In this policy, estimation of current assets is done after careful consideration of unforeseen contingencies and to avoid the risk associated with such contigencies, a cushion amount is kept at hand. These kind of firms assume little or no risk. This kind of planning ensures that the operating cycle runs smoothly. However the firm earns a lower return on investment because higher investment in current assets attract higher interest cost which reduces profitability.

When an organization maintains minimum amounts of cash, accounts receivable and inventory it is said to have a restrictive policy. The estumation of current assets for achieving targeted revenue is done without consideration for any provision or cushion amount. This kind of policies are aggressive without any tolerance for deviations. The level of current assets are maintained at a minimum level which in turn saves cost, increases profitability of the firm or higher return on investment. Though at the same time the risk is also higher due to an aggressive policy.

Thus the firm with a restrictive policy will have higher risk and higher return as compared to a firm with a conservative policy which will have a lower risk and return.