Introduction to the Cash Flow Cycle

The five circle diagram highlights several moments in the economic process where cash typically plays a critical role. We can start with the first circle, capital budgeting. The capital budgeting process involves senior management selecting which projects to invest in (as well as which assets should be divested, turning these assets into cash) and then gaining approval for those projects (or some subset) from the board of directors. Projects added to the firm must be financed, which means that the funding must be secured by which cash is transferred to other parties to pay for technology and other infrastructure (this appears in the balance sheet as additions to property, plant, and equipment). Capital budgeting projects are most often paid for by retained earnings, but may also be financed through asset sales, including new equity, borrowing (selling bonds or contracting for bank loans), or both. Retained earnings are usually in the form of cash, although some retained earnings may result from the creation of accounts receivable or be reduced by the creation of accounts payable The existence of accounts receivable (which are loans from the corporation in question to its customers) and accounts payable (which are loans made to the corporation in question by its suppliers) muddies the cash flow accounting because these contracts represent promises of other parties to pay the corporation or promises of the corporation to pay other parties. As with all promises, there is always a possibility of disappointment, of the relevant cash flows not being made (or only partially made). The key point to remember is that these loans must, at some point, be turned into cash to pay bills. Positive net cash flows are what businesses need to survive and, if they are so lucky, to grow. To further make this point, the second Circle involves the purchase of variable inputs, including labor time. In the United States, it is customary to pay workers after they have done the work. Workers may have to work two weeks or even a full-month before seeing a paycheck. This means the workers are actually lending money to the firm, but they, nevertheless, expect to eventually be paid in cash. Workers do not receive interest on their loan to the firm (and are unlikely to even know they have made a loan). This custom may be an odd twist on an old feudal custom of the feudal lord advancing cash to serfs (feudal workers) prior to the serfs providing surplus output to the lord. However, in this latter case, the lord tended to charge interest.

In any event, the capitalist firm has to have the cash in order to pay the cash. The cash cycle often finds the firm with insufficient cash to meet current costs, so finding a mechanism for putting off some of the costs was a solution to a very real problem. This cash cycle is not just about paying productive workers but includes the purchase of other variable inputs, such as electricity, water, component parts, and raw materials. Just as workers want to be paid in cash, so do suppliers of these other variable inputs, even if they allow accounts payable to put off the day when this cash is received. Failure to meet cash obligations when they are due can spell serious problems, even bankruptcy, for the corporation in question. The corporation is also obligated to pay taxes to governments and interest payments to bondholders and/or banks in cash with failure to do so leading to bankruptcy (except in cases where firms face soft budget constraints due to special protections from governments, such as those granted to state owned enterprises or firms deemed strategically important (or .too big to fail.).The five circle diagram highlights several moments in the economic process where cash typically plays a critical role. We can start with the first circle, capital budgeting. The capital budgeting process involves senior management selecting which projects to invest in (as well as which assets should be divested, turning these assets into cash) and then gaining approval for those projects (or some subset) from the board of directors. Projects added to the firm must be financed, which means that the funding must be secured by which cash is transferred to other parties to pay for technology and other infrastructure (this appears in the balance sheet as additions to property, plant, and equipment). Capital budgeting projects are most often paid for by retained earnings, but may also be financed through asset sales, including new equity, borrowing (selling bonds or contracting for bank loans), or both. Retained earnings are usually in the form of cash, although some retained earnings may result from the creation of accounts receivable or be reduced by the creation of accounts payable The existence of accounts receivable (which are loans from the corporation in question to its customers) and accounts payable (which are loans made to the corporation in question by its suppliers) muddies the cash flow accounting because these obligations. The key point to remember is that these loans must, at some point, be turned into cash to pay bills. That.s what businesses need to survive and, if they are so lucky, to grow. To further make this point, the second Circle involves the purchase of variable inputs, including labor time. In the United States, it is customary to pay workers after they have done the work. Workers may have to work two weeks or even a full-month before seeing a paycheck. This means the workers are actually lending money to the firm, but they, nevertheless, expect to eventually be paid in cash, workers do not receive interest on their loan to the firm (and are unlikely to even know they have made a loan). The firm has to have the cash in order to pay the cash. This is also true for the purchase of other variable inputs, such as electricity, water, component parts, and raw materials. Just as workers want to be paid in cash, so do suppliers of these other variable inputs, even if they allow accounts payable to put off the day when this cash is received. Failure to meet cash obligations when they are due can spell serious problems, even bankruptcy, for the corporation in question. The corporation is also obligated to pay taxes to governments and interest payments to bondholders and/or banks in cash with failure to do so leading to bankruptcy (except in cases where firms face soft budget constraints due to special protections from governments, such as those granted to state owned enterprises or firms deemed strategically important (or .too big to fail.).

If a firm must pay out cash (cash outflows) before it has secured the cash that must be paid out (cash outflows exceed cash inflows plus cash on hand), then the firm has a financing gap. It is possible for a firm to be profitable, yet cash flow negative. For example, accounting revenues may be created by selling products or services on accounts receivable, generating profits that are not in the form of cash. If the firm is obligated to make cash payments in excess of its revenues, even if the accounting profit is positive, then it may end up in bankruptcy proceedings in a court of law. Alternatively, the firm could try to sell its accounts receivable so as not to go bankrupt, but this means accepting that it will never receive 100% of its accounts receivable and the sell would have to be consummated (turned into cash) in a timely fashion.



Practice Exercise in Cash Flow Analysis (To be added)


 
 

Copyright © 2014, Satya Gabriel, Economics Department, Mount Holyoke College.