Understanding Financial Investments: Types, Maturity, and Profitability
Financial Function: Investing
An investment is an allocation of resources with the expectation of future benefit. This involves acquiring an asset with the hope that its value will increase or generate income.
Types of Investments
Investments can be classified in several ways:
- Asset vs. Asset Investments: Distinguishing between investments in different types of assets. Companies often consider investments in complementary assets and fixed assets.
- Financial vs. Productive Investments: Financial investments involve assets that materialize as financial obligations or actions, while productive investments involve assets used in producing goods and services.
- Role in the Company: Investments can also be categorized by their role within the company:
- Replacement and Maintenance Investments: Needed to replace worn or damaged equipment to continue production.
- Cost Reduction and Technological Improvement Investments: Replacing equipment with more efficient technology that requires less materials or energy.
- Expansion Investments: Expanding existing product lines or markets.
- Production Increase Investments: Aimed at increasing overall production capacity.
- New Products and Markets Investments: Diversifying production and extending distribution to new geographic areas.
- Imposed Investments: Investments made to satisfy legal requirements or union agreements, rather than purely economic motives.
Average Period of Maturation
The short cycle length (storage, manufacture, sale, and collection) is the maturing process. The average period of maturity is the average length of the short cycle, i.e., the average length of the process of storage, manufacture, sale, and collection.
PM = PMA + PMC + GMP + AP
Short-Cycle Phases:
- Storage: Phase where raw materials are stored. This is valued at cost price.
- Manufacturing: Phase where raw materials are processed, determining the cost of semi-finished products.
- Sale: The finished product is placed in the store of finished products. Its cost is determined by adding the production costs.
- Collection: Sale reduces the value of the finished goods warehouse, but increases credit to customers, valued at the sale price, unless recovered in cash.
Financial Maturity Period
The financial maturity period is obtained by subtracting the part of the ripening period that is funded by providers, allowing the company to postpone payments.
Cash Flow
Cash flow is the difference between the recovery of investment and the payments generated by that investment. If a company sells goods on credit and charges within three years, it is part of the current year’s income but part of the cash flow within three years, when the recovery occurs.
Expected Profitability and Performance Requirement
- Expected Profitability: The profitability expected from the investment.
- Performance Requirement: The minimum return an investor requires, considering factors such as inflation and the risk involved in the investment. Higher risk and inflation lead to a higher required return.
Significance as an Investment
The significance of an investment depends on the initial outlay required, the expected cash flows, the times when those cash flows are expected to be generated, and the risk involved.
Static and Dynamic Methods of Investment Selection
- Static Methods: Selection methods that do not account for the time value of money. A common static method is the payback period, which calculates the time it takes to recover the initial investment. Its disadvantages include ignoring cash flows prior to the payback period and ignoring cash flows after the payback period. Other static methods include total flow per monetary unit involved, average annual cash flow per currency compromised, comparison of costs, and accounting return rate.
- Dynamic Methods: Methods that incorporate the time factor and account for the depreciation of money. The principal methods are the Net Present Value (NPV) and the Internal Rate of Return (IRR). The Net Present Value (NPV) of an investment is the difference between its present value and its initial investment. The Internal Rate of Return (IRR) is the discount rate that makes the net present value equal to zero.