Why Companies Invest

Most companies generate cash from their operations. This cash can be used for the following purposes:

  1. Investing in current operations
  2. Investing in temporary investments to earn additional revenue
  3. Investing in long-term investments in stock of other companies for strategic reasons

1. Investing Cash in Current Operations

Cash is often used to support the current operating activities of a company. For ex­ample, cash may be used to replace worn-out equipment or to purchase new, more efficient and productive equipment. In addition, cash may be reinvested in the com­pany to expand its current operations. For example, a retailer based in the northwest United States might decide to expand by opening stores in the Midwest.

To support its current level of operations, a company also uses cash to pay:

  1. expenses.
  2. suppliers of merchandise and other assets.
  3. interest to creditors.
  4. dividends to stockholders.

The accounting for the use of cash in current operations has been described and illustrated in earlier chapters. For example, Chapter 9, “Fixed Assets and Intangible

Assets,” illustrated the use of cash for purchasing property, plant, and equipment. In this chapter, we describe and illustrate the use of cash for investing in temporary investments and the stock of other companies.

2. Investing Cash in Temporary Investments

A company may temporarily have excess cash that is not needed for use in its current operations. This is often the case when a company has a seasonal operating cycle. For example, a significant portion of the annual merchandise sales of a retailer occurs during the fall holiday season. As a result, retailers often experience a large increase in cash during this period, which is not needed until the spring buying season.

Instead of letting excess cash remain idle in a checking account, most companies invest their excess cash in temporary investments. In doing so, companies invest in securities such as:

  1. Debt securities, which are notes and bonds that pay interest and have a fixed maturity date.
  2. Equity securities, which are preferred and common stock that represent ownership in a company and do not have a fixed maturity date.

Investments in debt and equity securities, termed Investments or Temporary Investments, are reported in the Current Assets section of the balance sheet.

The primary objective of investing in temporary investments is to:

  1. earn interest revenue.
  2. receive dividends.
  3. realize gains from increases in the market price of the securities.

Investments in certificates of deposit and other securities that do not normally change in value are disclosed on the balance sheet as cash and cash equivalents. Such investments are held primarily for their interest revenue.

3. Investing Cash in Long-Term Investments

A company may invest cash in the debt or equity of another company as a long-term investment. Long-term investments may be held for the same investment objectives as temporary investments. However, long-term investments often involve the purchase of a significant portion of the stock of another company. Such investments usually have a strategic purpose, such as:

  1. Reduction of costs: When one company buys another company, the combined company may be able to reduce administrative expenses. For example, a combined company does not need two chief executive officers (CEOs) or chief financial officers (CFOs).
  2. Replacement of management: If the purchased company has been mismanaged, the acquiring company may replace the company’s management and, thus, improve op­erations and profits.
  3. Expansion: The acquiring company may purchase a company because it has a comple­mentary product line, territory, or customer base. The new combined company may be able to serve customers better than the two companies could separately.
  4. Integration: A company may integrate operations by acquiring a supplier or customer. Acquiring a supplier may provide a more stable or uninterrupted supply of resources. Acquiring a customer may also provide a market for the company’s products or services.

Source: Warren Carl S., Reeve James M., Duchac Jonathan (2013), Corporate Financial Accounting, South-Western College Pub; 12th edition.


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