The Influence of Financial Constraints on Corporate Liquidity Management - Essay Example

Financial Constraints and Corporate Liquidity Management

Introduction

The corporate liquidity management has been the growing topic of discussion in the corporate finance over the past ten years. Ensuring that the firm has the sufficient liquidity in order to be able to finance the valuable projects that occur in the foreseeable future is the central to the practice of the financial management. Yet, while research on these issues dates back at least to Keynes (1936), a substantial literature on the manner in which the firms should effectively and efficiently manage liquidity has developed only recently. These paper argues out that many of the fundamental issues in the liquidity management can be understood through the lens of the framework whereby the firms face the financial constraints and wish to ensure that there is efficient investment in the future. The paper will present such a model and then use it to survey a variety of empirical findings on the liquidity management. In today’s business management, one of the vital decisions that the financial manager should make is how liquid the firm’s balance sheet should be. In fact, managers prefer to hold the substantial portions of their assets in the form of the cash and the other liquid securities. As Keynes (1936) discussed, the main advantage of the liquid balance sheet is that it permit the firms to make the value-increasing investments when they occur. However, Keynes stressed out that, this advantage can be limited by the extent to which the firms have the access to the capital markets (Keynes, 1936 p.196). With these specific issues in mind, this paper will aim at understanding the effect of the financial constraints on the corporate liquidity management while drawing arguments from the various theoretical and empirical research. Central to this study is the idea that the managers use the liquidity as the way in which they maintain the financial flexibility in their firms.

Since the cash holdings are the most common ways in which the firms use to ensure liquidity, majority of the literature review has paid a lot of attention on the determinants of the cash holdings. Cash holdings vary both across the firms within countries and across countries, and also over some period of time (Campello, Graham, and Harvey, 2010). This study will discuss in a detailed manner the number of the studies examining both cross-sectional and time-series behaviour of the level of cash. As Keynes proposed, the underlying cause of the cross-sectional variation within the liquidity appears to be the variation in the financial frictions that the firms experience. Despite of this, it still remains a puzzle on why the level of the cash that is held by most of the firms varied so much, and in particular, the reason for the resurgence of the cash holdings in the recent years.

Critically, the corporate liquidity management can have numerous implications for the firm’s real operations such as employment, investment, mergers and the R&D (Hoberg, and Maksimovic, 2015). The understanding of the manner in which the liquidity management can alleviate the effect of the financial frictions on the real activity is of great vitality not only for the researchers, but also the policy makers. In that tune, the corporate liquidity management has been examined in reference with the issues such as investment in the R&D, collective bargaining and unionised labour, M&As, and product market competition (Hoberg, and Maksimovic, 2015).

Theoretical Literature

The issue of the liquidity management has been the subject of research for many scholars and practitioners. Keynes (1936) identified three main reasons why the agents should be holding the liquid securities: precautionary, transactions and speculative motives. The transactions motives mainly arises because there are some transactions costs that are involved in the raising of the funds, like the floatation costs. This is the motivation for the research which focus on the inventory-type models for the cash holdings, such as Miller and Orr (1966; 1968), Frankel and Javanovic (1980), Baumol (1970) and Meltzer (1963). The precautionary motive on the other hand (as discussed by Keynes) is related with the need for saving the cash so as to meet the future unexpected contingencies. The speculative motive says that the firms should be holding the cash because they might experience some liquidity difficulties in the future, and that it might be forced to surrender good investments because of the insufficient liquidity.

The notion that firms may underinvest owing to the insufficient or lack of the liquidity and the imperfect capital markets has been the centre of discussion in many classic papers in the corporate finance literature, such as Myers (1977), Jensen and Meckling (1976) and Myers and Majluf (1984). Kim et al. (1998) presented the model of the optimal cash holdings for the firms that face costly external financing. In their model, they proposed that the firms trade off on a lower return of holding the liquid assets, and that the benefit of having to relax the financial constraints in the future. Through this model, the authors derived implications for the optimal level of the cash holdings, asserting that those firms that have higher costs of external funds experience more profitable future investment opportunities and that they also have higher variance in regard to the future cash flows as they hold more cash.

In practice, various literatures focus on the cash that is mainly driven by the lack of the sufficient data on the alternative liquidity provisions mechanism like hedging and credit lines. Currently, it is possible to be able to incorporate the data that is linked with the other mechanisms into the corporate liquidity analysis. For instance, present research have found out that undrawn credit lines existence can be pivotal to the firm’s liquidity. Those firms that are holding the undrawn credit lines are more likely to hold some cash as well. However, those firms with limited access to the credit lines have more cash. Additionally, the foregoing research proves that cash can lead to the creation of the financial flexibility as it guarantees liquidity.

Bolton, Chen, and Wang, (2013) explored how hedging can impact the access to the external funding and investment. The researchers argued that quite a good number of the firms hedge using the derivatives by making the commitments that leads to the reduction of financial distress costs and reduce their chances of going bankrupt. This leads to substantial enhancement of their accessibility to the bank credits. Similarly, Keynes (1936) argued that if the firm has the unrestricted accessibility to the external capital markets, then there is no need for the firm to hold cash. In other words, what Keynes meant is that the holding of the cash becomes relevant in situations whereby the firm’s access to the external capital markets is highly restricted and that the vitality of the corporate liquidity management is highly dependent on the extent at which the firm is constrained financially. The same intuition was equally formalised by Almeida et al. (2004) in their model. They argued that firms will generally cash today in anticipation of being constrained in the future periods. However, owing to the fact that the financially constrained can only finance their current investment with the internal cash flows, the relatively higher cash flows leads to the lower levels of the current investments. As such, the financially constrained firms tends to determine the optimal cash policy through the balancing of the expected returns of the future and the present. In sharp contrast, the cash policy for the financially unconstrained can be termed as irrelevant because going by definition, they are simply “unconstrained”. In particular, their model predicts that the financially constrained firms should display the higher cash-flow sensitivity of cash as compared to the unconstrained firms. In order to demonstrate their model’s implications, Almeida et al. (2004) estimated cash flow sensitivity using a sample of the United States manufacturing firms between 1971 and 2000. The authors found out that the constrained firms showed positive cash flow sensitivity whereas those firms that were unconstrained did not.

Theory of Liquidity Demand

The liquidity demand model is used to explain the effect of the financial constraints on the financial performance of the firms. The theory is the representation of the dynamic challenge for the firm that is facing the financing and investment decisions in the imperfect capital markets (Diamond, and Rajan, 1999). In this particular setting, this paper analyse (using the liquidity demand theory) on how the firm can adjust to the cash holdings and the bank line holdings in reference to the cash flow innovation. This model is meant to provide the unifying framework that can help in the understanding many of the major results in the liquidity management literature. The theory proposes that, the firms’ demand for the liquidity arises due to the moral hazard problem that acts as an obstacle for the firms from pledging all of their cash flows to the outside investors (Hoberg, and Maksimovic, 2015). This framework also provides the insights into the some of the underlying reasons for the holding of the cash, the factors that impact on the cross-sectional and the time-series patterns in the cash holdings, and the value of having to hold cash relative to the other sources of the liquidity, such as, debt capacity, credit lines, or the use of the derivative to hedge (Diamond, and Rajan, 1999).

Empirical Evidences

A number of the recent studies examine the cross-section of the cash holdings and factors that are related with the higher levels of the cash. These research paper find that the cash level is positively related with the future of the investment opportunities, the business risks, and negatively with the proxies for the cost of the external finance, and with the level of the protection from the outside investors. While the previous studies have mainly focused on the differences of the cash level, this paper takes a close examination on the effects of the financial constraints on the financial management. These include the sensitivity of the cash holdings to the incremental changes in the cash flows, and the extent to which they are impacted by the financial status of the firm.

The strategy for the analysis of the corporate policies through the study of the cross-sectional differences in the cash flow sensitivities has been extensively explored by many empirical literature on the corporate investments that was initiated by Fazzari et al. (1998). While this literature was mainly focused on the corporate policies like the working capital (Fazzari and Petersen (1993) and Calomiris et al. (1995), and the inventory demand (Carpenter et al. (1994) and Kashyap et al. (1994), it has not extensively explored on the issue of the liquidity demand.

This paper’s findings on the agency aspects of the cash policies contributes to the literature providing the evidence that the firms that have huge cash flows holding try to undertake the sub-optimal and value reducing type of the investments. Blanchard (et al. (1994) carried a research of 11 firms that were receiving a large cash windfalls from the legal settlements. Although majority of these firms had poor investments opportunities, they did not pay extra cash to their shareholders or even reduce their debt. Instead, the management hoarded the cash and they later spent it on the value-reduction acquisitions. Harford (1999) proves that those firms that are very liquid (cash-rich) are more vulnerable to making the acquisitions. Lie (2000) also argued that the stock prices react positively to the announcement of the large cash-disbursements. He concluded that the cash-disbursements can be a mitigation factor for the problems that are related with the hoarding of the “excess funds”. Conversely, Opler et al. (1999) did not find any empirical evidence that the agency issues have any explanatory power for the cash policies.

In this empirical study, this paper found out that the patterns of the lower investment-cash flow sensitivities and the relatively higher cash flow sensitivities of the financially constrained firms are interrelated because the change in the cash balance and the investment are the two main competing uses of the funds. These findings can be linked to two possible explanations. First, it applies to the cases whereby the financially constrained firms have the positive cash flows. These firms will try to invest less as compared to their less constrained counterparts in reaction to the escalation in the cash flow because they are forced to build the liquidity buffer so as to make sure that they have sufficient funds for the future investments. As such, the financial constrained firms exhibit both the higher cash flow and lower investment cash flow sensitivities.

The second explanation is more appropriate in the period when the constrained firms incur the negative cash flows. As Allayannis and Mozumdar (2004) points out, the financially constrained firms are more likely cut their investments to the minimum levels in the periods of the negative cash flows. The additional decline in the cash flows will result to the additional investment cuts. This illustrates that, these firms cash flow-investment sensitivity is relatively lower. Also, facing the declining cash flows in the negative cash flows periods, the firms that are financial constrained may try to cover the shortfalls for the funds for the capital expenditure with the funds that can be sourced from the draining cash reserves. In connection to the increasing cash flows, the firms are more likely to restore the financial slack through the increase of the cash balance (Campello, Graham, and Harvey, 2010). As such, the higher cash flow and the lower cash flow investment can coexist in the firms that are financially constrained.

Conclusion

This paper has discussed the effects of the financial constraints on the corporate liquidity management through the investigation on how the firms manage their cash holdings (the internal liquidity) and also external liquidity (bank line holdings based on their financial conditions to ensure the financial liquidity. The investment decisions of those firms that are financially constrained are relatively much less sensitive to the availability of the internal funds as compared to the unconstrained firms. Regarding the effect of the financial constraints on the cash policy, the paper has found out that constrained firms exhibit much higher cash flow sensitivity as compared to the unconstrained firms. Additionally, this paper has also found out that those firms whose investments are constrained by the capital markets imperfections tend to manage the liquidity in order to be able to maximise the firm value. The study has provided a relatively new understanding regarding the corporate liquidity management and the ways in which the financial constraints impacts the corporate policies. Specifically, this paper has extinguished two sources of the financial liquidity (bank line or credits versus the cash) and further examined the responses of the two liquid capital holdings to the cash flow innovation with an aim of trying to detect the impact of the financial constraints on the corporate liquidity management. Although not discussed in the paper, it can be argued that dividend policy is sticky and play a rather passive role in the corporate liquidity management.

Appendix

Table 1 Empirical Work on the Quantity of the Cash that the Firms Hold

Cash and cash equivalents ($ billions)

Cash and cash equivalents/assets

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Table 1

Historical cash balances of large corporations.

Table 2 Time Series Evolution of the Cash Holdings, Undrawn Credit, and Total Liquidity

Firms that have no credit lines

Full samples

Firms that have the credit lines

mean

mean

mean

mean

cash

cash

undrawn

liquidity

mean

Period

Obs.

ratio

Obs.

ratio

credit ratio

ratio

Obs.

cash ratio

2002

4,230

0.218

2,079

0.135

0.146

0.281

2,131

0.3

2003

4,276

0.231

2,816

0.146

0.144

0.291

1,445

0.399

2004

4,265

0.238

2,810

0.151

0.140

0.291

1,439

0.408

2005

4,276

0.241

2,851

0.152

0.148

0.3

1,414

0.42

2006

4,175

0.239

2,797

0.148

0.142

0.29

1,372

0.425

2007

4,027

0.237

2,713

0.142

0.138

0.28

1,308

0.436

2008

4,076

0.219

2,691

0.132

0.138

0.27

1,378

0.39

2009

3,987

0.236

2,616

0.151

0.140

0.292

1,356

0.4

2010

3,500

0.238

2,328

0.148

0.140

0.288

1,148

0.421

The table above provides the summary of the statistics that are related to the undrawn credits, cash ratio, and the total liquidity level over the periods 2002-2010. The sample includes the firms from US that were covered by the Capital IQ.