PDF Ebook The Cash Flow Sensitivity of Cash
We use the link between financial constraints and a firm’s demand for liquidity to develop a new test of the effect of financial constraints on firm policies. The effect of financial constraints can be captured by a firm’s propensity to save cash out of incremental cash inflows (the cash flow sensitivity of cash). While constrained firms should have a positive cash flow sensitivity of cash, unconstrained firms’ cash savings should not be systematically related to cash flows. We estimate the cash flow sensitivity of cash using a large sample of manufacturing firms over the 1971-2000 period and find that firms that are more likely to be financially constrained display a significantly positive cash flow sensitivity of cash, while unconstrained firms do not. Also consistent with our argument, we find that constrained firms’ cash flow sensitivity of cash increases during recessions, while unconstrained firms’ cash—cash flow sensitivity is unaffected by macroeconomic innovations. The use of cash flow sensitivities of cash appears to be a theoretically justified, empirically useful method to test for the importance of financial constraints.
Two important areas of research in corporate finance are the effects of financial constraints, and the manner in which firms perform financial management. These two issues, although often studied separately, are fundamentally linked. As originally proposed by Keynes (1936), a major advantage of a liquid balance sheet is that it allows firms to undertake valuable projects when they arise. However, Keynes also argued that the importance of balance sheet liquidity is influenced by the extent to which firms have access to external capital markets (p. 196). If a firm has unrestricted access to external capital – that is, if a firm is financially unconstrained – there is no need to safeguard against future investment needs and corporate liquidity becomes irrelevant. Despite the link between financial constraints and corporate liquidity demand, the literature that examines the effects of financial constraints on firm behavior has traditionally focused on corporate investment demand.
(1988) propose that when firms face financing constraints, investment spending will vary with the availability of internal funds, rather than just with the availability of positive net present value (NPV) projects. Accordingly, one should be able to examine the influence of financing frictions on corporate investment by comparing the empirical sensitivity of investment to cash flow across groups of firms sorted according to a proxy for financial constraints. Recent research, however, has identified several problems with that strategy. The robustness of the implications proposed by Fazzari et al. has been challenged on theoretical grounds by Kaplan and Zingales (1997), Povel and Raith (2001) and Almeida and Campello (2002), while the robustness of cross sectional patterns presented in their empirical work (and in the subsequent literature) has been questioned by Kaplan and Zingales (1997), Cleary (1999), and Erickson and Whited (2000). Alti (2003) further demonstrates that because cash flows contain valuable information about a firm’s investment opportunities, the cross-sectional patterns reported by Fazzari et al. can be consistent with a model with no financing frictions (see also Gomes (2001)). This argument casts doubt on the very meaning of the empirical cash flow sensitivities of investment reported in the literature.
In this paper, we argue that the link between financial constraints and a firm’s demand for liquidity can help us identify whether financial constraints are an important determinant of firm behavior. We first present a model of a firm’s liquidity demand that formalizes Keynes’ intuition. In it, firms anticipating financing constraints in the future respond to those potential constraints by hoarding cash today. Holding cash, however, is costly because higher cash savings require reductions in current, valuable investments. Constrained firms will thus choose their optimal cash policy to balance the profitability of current and future investments. This policy is in contrast to that of firms that are able to fund all of their positive NPV investments: financially unconstrained firms have no use for cash, but also face no cost of holding cash (their cash policies are indeterminate).
The stark difference in the implied cash policies of constrained and unconstrained firms allows us to formulate an empirical prediction about the effect of financial constraints on firms’ financial policies. Our model suggests that financial constraints should be related to a firm’s propensity to save cash out of cash inflows, which we refer to as the cash flow sensitivity of cash. In particular, financially unconstrained firms should not display a systematic propensity to save cash while firms that are constrained should have a positive cash flow sensitivity of cash. As such, the cash flow sensitivity of cash provides a theoretically justified, empirically implementable measure of the importance of financial constraints.
The use of cash flow sensitivities of cash to test for financial constraints avoids some of the problems associated with the investment—cash flow literature. In particular, because cash is a financial (as opposed to a real) variable, it is difficult to argue that the explanatory power of cash flows for cash policies could be ascribed to its ability to forecast future business conditions (investment demand), even in the absence of financial frictions. For unconstrained firms changes in cash holdings should depend neither on current cash flows nor on future investment opportunities, so, in the absence of financial constraints, one should expect no systematic patterns in cash policies. Evidence that the sensitivity of cash holdings to cash flow varies systematically with proxies for financing frictions is therefore more powerful and less ambiguous evidence of the role of financial constraints than what investment—cash flow sensitivities can provide.
We evaluate the extent to which the cash flow sensitivity of cash provides an empirically useful measure of financial constraints using a sample of manufacturing firms between 1971 and 2000. We estimate that sensitivity for various subsamples, partitioned on the basis of the likelihood that firms have constrained access to external capital. We use five alternative approaches suggested by the literature to partition the sample in unconstrained and constrained sub-samples: firm dividend policy, asset size, bond ratings, commercial paper ratings, and an index measure derived from results in Kaplan and Zingales (1997) (the “KZ index”). We find that, under each of the first four classification schemes, the cash flow sensitivity of cash is close to and not statistically different from zero for the unconstrained firms, but positive and highly significantly different from zero for the constrained firms. The KZ index generates constrained/unconstrained firm assignments that are mostly negatively correlated with those of the other four classification criteria. Not surprisingly, we obtain the very opposite results for our estimates of the cash flow sensitivity of cash that use the KZ index. 2 All of the patterns remain after we subject our estimations to a number of robustness checks involving changes in empirical specifications, sampling restrictions, and econometric methodologies. Our findings are fully consistent with the implications of our model of corporate liquidity.
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