CURRENT ASSET MANAGEMENT APPROACHES - Working Capital Management

How does a management fix appropriate level of investment in current assets? This question may be viewed in an aggregative or disaggregative context. Let us consider in an aggregative context, the question becomes: level of investment in total current assets vis-à-vis fixed assets? In the disaggregative context, the question becomes: How does a management fix appropriate level of investment in individual current assets viz: investment receivables, cash and marketable securities. Let us explain in the following: The three broad approaches which the management may take to arrive at appropriate level of investment is current asset industry Norm approach. In this approach, the industry practice is used to arrive at target level of investment in current assets. There would be a year to year and inter-firm fluctuations and differences over a period of time in the industry, adjusting to its environment and risk expected to have settled down to some average number – 30, 60 or 90 days of raw material consumption as inventory. The problems in the following approach are:

  1. it can be less of a reality and more of a myth;
  2. everyone might more or less do what others are doing, resulting in imitative behaviour;
  3. the possibility of drifts determined by environmental changes are inadequate internal adjustments; and
  4. absence of an impetus to search for better solutions than those embedded in the norms through economic or strategic choice approach.

In spite of these problems, the industry norm approach has survived by force of history and tradition. A careful use of this approach can under certain conditions provide useful benchmark especially for new entrants.

ECONOMIC MODEL APPROACH

The economic model approach signifies an explicit rational model of profit maximization or cost minimization. The approach arrives at an optional solution for a specific case making trade-off between risk and profitability, using economic decision criterion. Economic order quantity model explained in Block 2 is a typical example of this approach.

The economic model approach avoids the myth of the mean implicit in the industry norm approach. It is nearer reality in basing itself on the assumption that every company at a particular point in time represents more or less a unique case. Even so, the approach has been tried in a limited way, in part, because of its restrictive assumptions and exclusive reliance on financial or economic variables and not on total conditions. This approach however incorporates the profit motive interest in business decision. Even if indicative solutions could be provided by such models, it could prove helpful in day-to-day management of funds.

STRATEGIC CHOICE APPROACH

It is possible to take the position that there are no ideal solutions to the working capital problem of a company. As condition and goals changes, solution must be worked out every time to fit each unique situation without letting conventional restrictions limit our choice. There is this concept of strategic choice involved in the area of current assets management. Having scanned its environment and set its goal including those on profitability, a company can decide that it should maintain a certain number of days of raw material inventory necessary to achieve its goals. The same would apply to in-process and finished goods inventories as well as to book debts. The spirits behind the strategic choice approach is innovative behaviour selling up a new function, a new arrive, a new set of total conditions. The effect is to gain competitive strength through a wider and more flexible range of choices. There is no dependence on decision rules, policies or conventions, self-imposed constraints are released, and it asks the basic value question: do resources determine choice or do choices determine resources?

The strategic choice approach is based on the assumption of a highly competitive environment and the existence of a few ambitious competitors who would be willing to take the risks to build competitive strengths. It would be unrealistic to assume that all companies in all industries could adopt the strategic choice approach. There has been a clear shift in favour of this approach in many businesses experiencing competitive environment.


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Working Capital Management Topics