A Structural Model of a Firm’s Operating Cash Flow with Applications

Effective management of a firm’s operating cash flow is essential for supporting growth, servicing debt, and maintaining overall financial health. Mismanagement of cash flows can result in severe liquidity challenges and even business failure. However, managing operating cash flow is complex because of its intricate, endogenous relationships with operational variables, like sales, operating costs, inventory, payables, and the impact of exogenous macroeconomic factors on a firm. In this paper, we present a structural model of operating cash flow that untangles this endogeneity, allows us to estimate causal relationships among these variables, and provides a valuable tool for evaluating cash flow management policies. Applying our model to quarterly financial data from S&P’s Compustat database spanning from 1990 to 2020 along with macroeconomic indicators, we provide empirical evidence of the endogenous nature of cash flow with other operational variables. We then showcase the practical value of our model by (i) identifying the characteristics of structural shocks and the new equilibria they induce within the system; (ii) offering a tool for evaluating alternative managerial actions or policy decisions to counteract these shocks; (iii) predicting the impacts of macroeconomic events, such as global recessions and fluctuations in economic sentiment, on firm performance; and (iv) demonstrating superior forecasting performance compared with traditional univariate models. In summary, our structural model of operating cash flow enhances our understanding of its dynamics, enabling better-informed decision making and more effective cash flow management in firms.