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How to make cashflow work for you

Understanding cashflow patterns could help not only your own business but also the wider economy, says researcher Dr Xin Chang.

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Xin (Simba) Chang

Dr Xin (Simba) Chang

Entrepreneur Ed Reeves is proud of the fact that he sent his first invoice to his first ever customer before he’d provided any actual service. “It was a strategy borne of necessity,” says Reeves, the founder of telephone answering service Moneypenny, “but it was a deliberate one. We couldn’t believe the number of similar businesses that did ‘post facto’ invoicing – which means you never know when the money’s coming in.”

“We looked at the mobile phone industry, where the customer always pays in advance, and applied that right from the start. It’s a risk when you’re an unknown business, but it was either that or simply not get any further.”

This type of pragmatic approach to cashflow reflects its importance to all businesses, large or small. The problem is, there are no hard and fast rules for doing this. If your firm is finding its finances a bit tight, do you hoard any spare cash for an emergency that may never come? Or do you invest for growth and risk an unforeseen fiscal black hole?

How organisations manage their cashflow affects not only their own business, but the ecosystem in which they operate – and ultimately the wider economy. Therefore understanding behaviour patterns in how and why that money moves is vital, from individual businesses all the way up to government.

“Cashflow keeps business moving,” says researcher Dr Xin Chang. “Understanding these patterns can inform government tax policy, interest rates or a host of other financial decisions that impact how organisations operate, and therefore influence the economy.”

Dr Chang and his colleagues studied data from numerous US firms between 1971 and 2011, to examine how those businesses allocated their internally generated cashflow (which they define as the amount of cash generated by a firm as a result of its production and sales of goods and services after all expenses) to a range of uses – corporate investment, adding to cash holdings, paying of dividends, repurchasing equity and repaying loans. Breaking the figures right down to how many cents in each dollar were allocated to each destination, they found the greatest use of cashflow is for reducing reliance on external financing, with adding to their cash holding a close second.

“In response to a one-dollar increase in cashflow, firms allocated 33 cents on average to cash holdings and 38 cents to reducing the use of external (debt and equity) capital,” reports Dr Chang. Investment, by contrast, was a distant third at 28 cents. Finally, a one-dollar increase in cash flow increases dividends by only one cent. It seems that firms primarily use internally generated funds to substitute for external sources of funds and build up cash reserves, instead of using them to make new investment or pay dividends.

“Those more financially constrained organisations substitute more external capital than do less constrained firms,” says Dr Chang. “This is consistent with the idea that they expect to face even greater constraints in the future, thereby saving more cash for precautionary motives and enhancing their ability to raise additional external capital in the future.”

They also found that when cashflow reduced by a dollar, less financially constrained firms, which have greater access to external capital markets, reduced new equity financing by three or four cents – but their more cash-strapped counterparts cut their equity financing by three times as much.

Cambridge Judge’s Dr Chang and his colleagues from Hong Kong and Chinese universities used four decades of data from Compustat to develop five equations that described five main uses of cashflow. These will, they hope, provide a format by which policy makers can more effectively understand the patterns that organisations follow when allocating their internally generated funds.

“The idea that more financially constrained firms allocate less cashflow to investment than those who are less constrained may appear surprising,” says Dr Chang. “It has always been assumed that they should rely more on internal cashflow for investment, given their restricted access to external capital markets. But they are actually more willing to use that cashflow to boost cash reserves and reduce the amount of costly external finance – and that leaves less available for investment.”

Understanding how firms allocate internal cashflow is also important for economic policy, which is often formulated in response to perceived misvaluation in asset markets: for example, monetary tightening to deal with asset bubbles or monetary easing to alleviate depressed stock market conditions. If firms use cashflow to primarily build up cash balances or reduce the amount of debt and equity outstanding, then the effect of economic policy, such as tax and interest rate cuts, which aim at improving firms’ profitability and spurring investment, may be muted. Understanding how firms allocate cashflow across various uses under various market conditions may improve the effectiveness of economic policy in influencing firm investment and saving decisions.

Moneypenny is now the UK’s leading outsourced switchboard provider – and has maintained a solid grip on its cashflow, which enables it to plan very rigidly how any excess is used. “Recurring revenues make an enormous difference,” says Reeves. “I know more or less exactly how much money we’ll have in three and six months’ time. That means we can allocate a steady percentage of our cashflow to various uses – 12 to 14 per cent, for example, goes on marketing, and those recurring revenues means we have got a clear idea exactly how much that budget will be. It also enables you to look to the longer term. We have also used the cashflow to build up a ‘war chest’ to expand the business.”

Ed Reeves appears surprised more businesses don’t do the same. “Companies are catching on, including very major ones. Microsoft is now charging £5.99 a month in advance to use Office, and their cash position is suddenly sky-high. But there are opportunities for all sorts of businesses – instead of charging for the last three months they could, say, offer a 10 per cent reduction in exchange for fixing rates going forward. If more companies did this, it would inevitably lead to a greater management of cashflow and more consistent use of it in business and throughout the wider economy.”