Corporate liquidity management has been a growing research area in corporate finance during the past ten years. Meanwhile, the effect of financial constraints on corporate behaviors remains to be a topic of continued interest. Despite the extensive research on each subject, few studies have been done by combining these two research lines to examine the effect of financial constraints on corporate liquidity management.
Previous literature in corporate liquidity management and financial constraints have largely concentrated on the role of cash holdings (we call it as “internal liquidity”). For instance, Opler et al. (1999) examine the determinants and implications of holdings of cash and find that firms with strong growth opportunities and riskier cash flows hold more cash. Almeida, Campello, and Weisbach (2004) show that the effect of financial constraints can be captured by the firm’s propensity to save cash out of cash flows (“cash flow sensitivity of cash”). However, these studies do not consider the role of bank lines of credit (we call it as “external liquidity”). Given that bank lines of credit serve as a viable liquidity substitute to firms and help reduce capital market frictions (Holmstrom and Tirole (1998)), it would be surprising if one does not take into account the external liquidity when studying the effect of financial constraints on corporate liquidity management.
A recent paper by Sufi (2006) examines the factors that determine whether firms use bank lines of credit or cash in corporate liquidity management. The author finds that firms with low cash flow are less likely to obtain a line of credit and thus rely more heavily on cash. Sufi’s paper is one of the first empirical studies on the role of bank lines of credit in corporate finance, however, it does not explicitly examine how firms optimally manage financial liquidity using both cash and bank lines of credit. Rather, Sufi focuses on firms’ cross-sectional variation in use of cash or bank lines and concludes that use of bank lines of credit is, to some extent, determined by banks based on firms’ cash flows.
As documented in Sufi (2006), over 80% of firms across different industries have access to bank lines of credit during the period of 1996-2003. Given this fact, it is interesting to ask how these firms manage financial liquidity by holding cash and acquiring bank lines in order to hedge against future capital shortfalls for potential investment. In particular, one can argue that, although banks have certain degree of power in controlling firms’ use of bank lines, essentially it is firms themselves that design optimal cash policy and bank debt policy to meet financial liquidity needs. Moreover, for the majority of firms, a key determinant in financial liquidity management is the hedging cost associated with liquid capital from different sources. Thus, one would expect that these firms should manage financial liquidity to hedge against future capital shortfalls while minimizing hedging costs based on their financial conditions.
This paper investigates how firms with different financial conditions adjust two sources of liquid capital (i.e., cash holdings and bank line holdings) in response to their cash flows. Our focus is to understand the effect of financial constraints on corporate liquidity management. We emphasize the hedging perspective of corporate liquidity management, that is, firms dynamically adjust cash holdings and bank line holdings to hedge against potential capital shortfalls. The effect of financial constraints is captured by the different responses of the two sources of liquidity to cash flow innovations by firms with different financial conditions. Besides, we also explore issues related to dividend policy in the context of corporate liquidity management. Dividend policy is relevant here because paying out more dividends reduces firms’ internal cash flow and thus affects their liquid capital holdings. By examining dividend payout behaviors in the context of liquidity management, we provide new insights about corporate dividend policy.
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Corporate Liquidity Management and Financial Constraints
