Financial managers often view the balances their companies have in Current Asset

Question

Financial managers often view the balances their companies have in Current Assets and Current Liabilities the result of an investment decision.  Discuss why these balances can be viewed as “investment” decisions.

Two companies manufacture can openers.  Relevant data follows:

                                                                          Old School                                      Hi Tech

  Manufacturing, Inc.                      Manufacturing, Inc.

               Degree of Operating Leverage                   2.2                                             5.7

               Degree of Financial Leverage                    1.5                                             3.3

Which of these companies is more at risk?  Why?

Which of these companies has a lower break-even point?  Why?

Discuss what advantages a labor intensive company has over a capital intensive company.

Discuss the advantages a capital intensive company has compared to a labor intensive company.

Discuss how “offshoring” has impacted the leverage question.

Explanation / Answer

The reason balances in current assets and current liabilities can be used as investment tools to make wise decisions are because they provide a snapshot of the company's wealth versus debt. If the company was forced to pay back their short term liabilities, the liquidity ratio would give an idea as to whether or not the company will be able to withstand changes in the economy. A company may be better managing its excess cash position by investing it in short term investments and earn return on it while ensuring that they meet short term liabilites with sufficient liquid assets time after time. This will require shrewd investment decisions and thus is an integral part of the investment decision making process.

2) Degree of total leverage = degree of financial leverage * degree of operating leverage

For Old school manufacturing = 1.5 *2.2 = 3.3

For Hi tech manufacturing = 5.7 * 3.3 = 18.81

High tech manufacturing is facing high risk with regards to its fixed costs as well as interest payments

Degree of financial leverage = EBIT/(EBIT - interest)

3) Old school manufacturing has a lower degree of operating leverage thus is incurring a lower fixed cost.

since DOL = (sales - variable costs)/( (sales - variable costs) - fixed cost)

Thus Old school manufacturing is having lower break even point since breakeven point = (sales - variable cost)/Fixed cost

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