Once a corporation has been organized and investors have provided money for its operation, it is the duty of management to invest these funds in productive resources. In the accountant’s terminology these resources are assets. The assets of a company are of two main kinds, fixed assets, and current or circulating assets.
Fixed assets are the tools of the business, land, buildings, machines, showroom fixtures, vehicles. These are used to produce goods and services. They deteriorate through age and use, and become obsolete because of technological advances in science and the arts. Fixed assets are used by business to act upon current capital. Current capital consists of raw materials being transformed into finished products On hand for sale, unpaid accounts of people who have bought on credit, and the cash or equivalent necessary for operation of the business.
The second major task of financial management is allocation of the corporation’s capital among current and fixed assets to provide smooth operation and as much profit as possible. Arthur Stone Dewing has sketched this relationship in a picturesque passage:
If the fixed capital of a business can be likened to a mill, the current capital is the grist the mill grinds. It is the function of the mill to transform a steady flow of grist into a product that can be sold for more than enough to pay for the original cost of the grist and for the operation of the mill this flow of goods-raw materials, goods in process of manufacture, finished goods, ledger accounts and notes arising out of sales of goods, and the cash recovered from these sales waiting to be spent again for raw materials-these, altogether, are called current capital. The mill is without economic justification except as it has grain to transform into flour; the grain cannot be consumed until it is ground in the mill. The business is the mill and the grist together; the one cannot perform its economic function without the other.
At least three major factors affect management’s allocation of resources between current and fixed capital. First, different kinds of businesses need different combinations of assets illustrate the asset requirements of various important American industries. The steel industry requires a large investment in plant and equipment, while tobacco companies, service companies (such as advertising agencies), and finance companies require relatively little investment in this type of asset. Tobacco companies and department stores, on the other hand, need large inventories, while agencies and finance companies require little, if any. Advertising agencies, finance companies, and department stores typically have relatively high receivables.
There are exceptions to this rough classification, and there is often great diversity within an industry. But the argument for a successful blend of current and fixed capital is persuasive, and although bankers and credit-granting agencies stress liquidity of current capital-the speed with which it can be realized in cash in the normal course of business-its main characteristic is its relationship to the fixed assets of the business.
Within a particular industry the best combination of current and fixed capital varies during the year. Thus the second factor affecting this relationship is the seasonal nature of the supply of a raw material and the demand for the product. Sometimes the supply of a raw material is either sporadic or seasonal. If it is one that must be ordered well in advance, a large reserve may be needed in order to avoid costly shortages. Supply for the frozen food industry is highly seasonal. For some frozen products, raw materials for an entire year’s sales must be purchased and frozen in the span of a few days.
Industries with seasonal demand are common. A good example is the toy industry-retail toy stores concentrate their orders for toys in the early fall in anticipation of heavy sales in November and December. The manufacturer therefore builds his inventories to a peak in the late summer and has high receivables and low inventories late in the year as a result of sales, and low inventories and receivables in early spring. The retailer, on the other hand, has high inventories in the fall and relatively low inventories and high receivables from Christmas sales in the first months of the year.
The third major influence on the relationship of current and fixed assets is the state of the economy. Fluctuations are frequent. Slight recessions occurred in 1958, 1961, and 1969, and there were periods of rising economy between. A company which suddenly experiences a shift from a rising to a decreasing market may find itself with much higher inventories than it expected. In 1969-70, consumers for a time stopped buying television sets, automobiles, boats, and other durable goods at the expected rates. They did so for many reasons, among them inflation and high interest rates. As a result these industries experienced higher than normal inventories and lower profits.
We are now in a position to see why debt is an important source of capital and why there is a need for short-term debt. We have spoken several times of the circulating nature of current assets. The cycle of many business operations includes purchasing inventory, converting inventory, selling inventory, collecting receivables and purchasing inventory once more. This circular flow rotates from cash to inventory to receivables to cash. The operation between cash and inventory is purchase of inventory; the operation between inventory and receivable is a sale; and the operation between receivable and cash is collection of receivables. It is understood that the inventory box represen s a conversion of inventory from purchase state to salable state. For a manufacturing company, this means transformation from raw material to finished goods. For a retailer, it means making items available for consumers to purchase. For the successful company, this circular flow increases in magnitude as the company continues to have more revenues than cash expenses.
The very simple business which starts with enough cash may operate on this simple model and need no short-term borrowing. For example, a small gasoline service station which buys and sells for cash may be able to operate this way. But few companies are so simple in operation-even most small neighborhood companies are much more complicated than this.
The complicating factors are of four general kinds, all closely related. First, the company may not have enough available cash to purchase the initial inventory. Second, it may not be able to sell the inventory before it must pay for it. Third, the business may not be able to collect receivables before it needs to purchase new inventory. Fourth, there may be other business demands for the available cash.
