Cash Flow - Financial Management

The concept of cash flow is one of the central elements of financial analysis, planning, and resource allocation decisions. Cash flows are important because the financial health of a firm depends on its ability to generate sufficient amounts of cash to pay its creditors, employees, suppliers, and owners. Only cash can be spent. You cannot spend net income because net income does not reflect the actual cash inflows and outflows of the firm. For example, an accountant records depreciation expense in an attempt to recognize the decline in value of an asset over its life. However, depreciation expense requires no cash outlay, because the entire cash outflow occurred at the time the asset was purchased.

The Cash Flow Generation Process

Financial managers are concerned primarily with raising funds (cash) for use by the firm and investing those funds in assets that can be converted into a stream of cash flows accruing to the firm and its owners. If the value today of the stream of cash flows generated by the assets of a firm exceeds the cost of those assets, the investments undertaken by the firm add value to the firm.When financial managers perform this primary function of acquiring funds and directing the investment of those funds into value -maximizing projects, they must balance the risk (variability) and timing of the expected cash flow stream against the magnitude of the expected returns.

The cash flow generation process for a firm. A firm can raise funds by issuing different types of financial securities, including both debt and equity types.20 Financing decisions such as these are summarized on the liabilities and owners’ equity side of the balance sheet. In addition to selling securities, a firm can raise cash by borrowing from a lender such as a commercial bank. Funds can also be raised by generating cash flow internally. Internal cash flows include cash generated from operations and cash generated by the sale of assets.

A Firm’s Cash Flow Generation Process

A Firm’s Cash Flow Generation Process

Once cash is available, a decision must be made to invest it in one or more assets. The acquisition of the best long-term assets is crucial, because once acquired, long -term assets impact the firm for a long time. Long -term assets can be sold if necessary but sometimes only at a significant loss. Current assets, or working capital, such as cash, accounts receivable, and inventory, are held for operating purposes and generally offer little or no explicit return.

If current asset balances are kept too high, shareholder wealth is sacrificed due to the opportunity cost of funds, that is, the returns that could be earned if these funds had been invested elsewhere. On the other hand, if current asset balances are too low, the risk of the firm increases because the firm may encounter difficulty in meeting its current financial obligations. In addition, low current asset balances (particularly inventories and accounts receivable) may prevent a firm from responding to the needs of prospective customers in a timely and profitable way.

Eventually, all assets are transformed into a cash flow. Plant and equipment generate a product or service. Inventory is gradually sold and generates cash sales or accounts receivable. Cash flow is generated as accounts receivable are collected. Then, the firm must decide how much of its cash flow to use to acquire additional assets, pay off creditors, and distribute to its owners.

Importance of Cash Flows

The valuation of debt and equity securities is based upon the present value of the cash flows that these securities are expected to provide to investors.21 Similarly, the value of a capital expenditure is equal to the present value of the cash flows that the asset is expected to produce for the firm. In addition, cash flows are central to the prosperity and survival of a firm.

For example, rapidly expanding firms often grow faster than their ability to generate internally the cash flows needed to meet operating and financial commitments. As a result, these firms may be faced with difficult financial decisions regarding the external sources of funds needed to sustain rapid growth. On the one hand, increases in debt to support expansion result in an increase in the firm’s financial risk.

On the other hand, if new shares of stock are sold, ownership in the firm may be diluted more than is desired by the firm’s controlling group of owners. Therefore, managers need to pay close attention to the projected cash flows associated with investment and firm expansion strategies. As a consequence, GAAP concepts of net income do not provide a clear indication of the economic performance of a firm. Cash flow concepts are unambiguous and provide the necessary insight for managers making a wide range of financial resource allocation decisions.

Investors also find that cash flow concepts provide a clear measure of performance. Accordingly, the concept of cash flow assumes great importance in the analysis of a firm’s performance and the management of its resources.

Cash Flows and Shareholder Wealth

In spite of the close tie between cash flow concepts and the objective of shareholder wealth maximization, many managers do not seem to place enough emphasis on this concept. Some managers focus on alternative performance measures, including accounting net income, accounting profit ratios (such as the return on equity or the return on assets), the sales growth rate, and market share.

The focus on these accounting -based measures of performance may detract from the long -term performance of the company, because performance measures that are not based on cash flows are subject to short -term manipulation by managers. By emphasizing cash flows rather than accounting -based measures of performance when making decisions, a manager is more likely to achieve the objective of shareholder wealth maximization. A firm that takes actions to maximize the present value of expected future cash flows will achieve a record of financial performance that will be reflected both in the company’s financial statements and in the market value of its stock.

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