Question

In: Finance

Your CFO tells you as finance manager that he feels much safer to have a smaller...

Your CFO tells you as finance manager that he feels much safer to have a smaller inventory and cash level than before. What are trade-offs involved in the decision of how much inventory or cash the firm should carry. Answer for both inventory level and cash level separately.

Solutions

Expert Solution

The firm when holding the inventory decides to hold an inventory level at which the firm can maximize its turnover but also is not able to miss customer and increase sales level. The trade off involves in holding inventory level is if it is holding high inventory and then there are storage cost of inventory and if he is not able to sell the inventory on time then there would be spoilage and loss to the company on the other hand if he is holding low inventory then he might not be able to meet the customer demand and might lose on the sales. It is very important for companies to find a level of inventory balance where they can maximize the revenue and at the same time the cost of holding the inventory and the number of days the inventory is being hold is low.

In terms of cash, when a company is holding a cash balance then it can either choose to invest in short term liquid funds or it can choose to keep it to themselves and in that case, they would not be earning any interest. The tradeoff involved here is of earning return vs meeting the cash needs. When the company chooses to invest it has to maintain enough liquidity to themselves so that they are able to pay off their suppliers and meet their short-term working capital requirement. Holding low level of cash can cause liquidity issue while holding high level of cash can cause the company to lose returns which it could have earned.


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