Cash flows, especially unanticipated ones, raise questions about how firms use these funds. Are they more likely to invest them? Pay dividends? Reduce debts? Do financially constrained firms use them differently from unconstrained firms?

These questions are tested in a study by Sudipto Dasgupta, Thomas H. Noe and Zhen Wang that shows cash flows have both short and long term impacts as firms initially use the money to reduce debt overhang and build up cash holdings, then proceed to invest more in the long term. Financially unconstrained firms invest greater amounts because it is easier for them to raise external financing to support this.

The appeal of this approach is that reducing debt and increasing cash holdings make a company more attractive to lenders and investors.

"Additional cash inflow enables firms to carry more liquidity on the balance sheet, which can ease financing constraints in the future," say the authors. "Moreover, by reducing external borrowing [in the short term], firms can possibly avoid greater debt overhang in the future, which allows more investment and leads to additional external financing."

The authors looked at data from 3,845 U.S. firms in the first, second and third year after a cash flow shock, from 1971 to 2006. They focused on the four main uses of operating cash flow - cash holdings, reducing external financing, investment and dividends.

In the first year, 36 cents of every one dollar increase in cash flow was immediately saved. Some of this was used over the following two years but at the end the firms still held on average 25 cents in cash holdings.

Firms also spent a large fraction of an extra dollar of cash flow in reducing external financing: a one-dollar increase in cash flow replaced external financing by 50 cents (although for the next two years it caused firms to raise more external financing, possibly because reducing debt had allowed for more investment in future).

On investment, firms immediately spent a modest 12.6 cents per dollar in this area, but in the next two years spent 25.7 cents on investments and 2 cents on dividend payouts. This showed the overall investment response to cash flow was larger and manifested over a longer horizon than previously thought, and confirmed the conventional wisdom that dividend policies are sticky even over a longer period, the authors say.

The degree of financial constraints on firms resulted in differing reactions, though. Financially constrained firms - those that had more difficulty raising external financing - were more likely to try to finance investment internally and use their cash holdings to that end. For example, at the end of three years constrained firms saved almost twice as much as unconstrained firms: 33.2 cents per dollar as against 16.7 cents.

Constrained firms also spent less over three years - 28.7 cents as against 64 cents - and raised significantly less external finance in the two years after additional cash flows - 10.9 cents as against 31.8 cents for unconstrained firms.

"Our results show that it's important to consider cash flow sensitivities in both the short and long run," the authors conclude. "We find a substantial difference between the short term and cumulative sensitivity of investment to cash flows, especially for unconstrained firms. In the short term firms mainly reduce external financing and add to cash balances when their cash flows increase. However, these actions expand the investment potential and lead to additional external financing and investment in the next two years."