Cash Flow Cycle of the Firm

These pages are designed for students in Intro to Finance and other elementary Finance courses.

These pages are not meant to replace you textbook. They are provided as an adjunct to help you with practical problems and assignments.

Understanding the cash flow cycle of a business firm is critical to successful financial management. Since finance students often do not have any managerial business experience in the finance area, misunderstandings about how cash moves through a business can make all topics appear mysterious. This tutorial is provided to give this basic knowledge about the lifeblood flow in a business.

The term liquidity is often used to describe the ability to pay bills when they are due. Liquid assets include cash and a few other things that can be sold, [not inventory] to raise cash immediately. Fixed assets are buildings plant and equipment, short term assets are inventory and accounts receivable are routinely converted to cash as part of the cycle.

The diagram shown below is taken from [] and is the type often used to illustrate the cash flow cycle using the analogy of water.

Notice the central cash reservoir. This is the balance in the cash [checking account] that the financial manager must never let run out. If it runs out somebody is not going to be paid. A worst case scenario would be a default on a legal obligation followed by bankruptcy. Also notice that the main flow of cash is from the cash reservoir, through inventories, shipments to customers and accounts receivable and back to cash. Everything else in the system is there to support this flow.

Cash Flow Descriptions

• Reservoir #4 share owners. The common stockholder that really own the company could be asked for more money. The way that this is done is through the issuance of additional stock to the public. This is not done very frequently, is expensive, and takes months to implement.
• Reservoir #3 Borrowing capacity. Businesses use banks for short term loans to supplement the cash reservoir when needed, often several times per year. These loans are repaid whenever the cash reservoir goes above the planned level. The firm pays interest on the outstanding balance only. The capacity of this reservoir is called the line of credit. This line is negotiated with the bank before it is needed.This line of credit must be larger than the External Financing Needed as determined by the financial forecast. The bank tries to protect its position by making restrictions on borrowers. These restrictions are couched in terms of limits on certain financial ratios, especially the current ratio and the debt ratio.Violation of these limits is usually what provokes a liquidity crisis in a firm!
• Reservoir #2 Marketable Securities. This is the Commercial Paper Market segment of the Money Market. It is an alternative for bank borrowing for only the largest firms with perfect credit ratings. It is unavailable to most ordinary sized businesses. Basically the firm writes IOU's for very large amounts payable at some future date and sells them at a discount in the Money Market, [over the telephone].
• Interest. This is a one way drain. These payments must be made on time or a legal default will occur.
• Plant and Equipment. This is also a one way drain of cash since most firms keep assets until they wear out rather than sell them. An alternative to this is leasing. The difficulty with this drain is that when it occurs it can be a really big one like flushing a toilet. Much planning is required. This is the subject of capital budgeting.
• Inventories and manufacturing expenses. The main drain. There are two things to keep in mind. There is a constant flow through here. The flow is not constant and even. Inventories are built up to handle the unevenness of sales and to minimize costs of production. Higher levels of sales demand higher levels of inventories. Higher variability of sales demands higher inventories. Greater variety of product demands higher inventories. This is a major headache for the business and many crises develop because the production and inventory get out of whack.
• Operating expenses. Another one way drain. This is the cash spent for expenses not directly related to production. Overhead is another word used.
• Dividends. Most corporations that pay dividends to the stockholder pay them four times a year. Many stockholders depend of these dividends to live. Although they can be skipped without causing a default, stock prices will fall, stockholders will be unhappy and managers may be fired!
• Income taxes. Corporations that make money pay income taxes. They must be estimated and paid quarterly. A corporation may get a refund when losses occur.
• Accounts receivable. This is what we wait for! If everything goes as planned the flow into the cash reservoir from this source will be large enough to meet all the drains with some left over for growth. For many firms this inflow is very uneven and unpredictable. The greater the unpredictability the bigger the cash balance must be to avoid a crisis.

A financial manager must be able to look at any of the events that occur in a firm and be able to predict what and when the resultant cash flows will be. This is very difficult to do and is one of the reasons financial management can be a very stressful occupation.

Comments and Suggestions should may be sent togramborw@tiger.uofs.edu