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

The Influence of Financial Constraints on Corporate Liquidity Management

Introduction

The primary purpose of corporate liquidity management is to ensure that a firm has easy access to capital. High and low-leveraged corporates sustain long-standing relationships with external financiers to have consistent funding cash for meeting needs (Soprano, 2015). Meeting the cash and collateral obligations maintains profits and prevents a firm from incurring losses. Subsequently, the financial health of a corporate is due to an adequate liquidity, which further helps a corporate to carry out daily operations. The common practice among firms has been coordination of diverse funding sources available irrespective of the existence of normal or stressed financial conditions. Corporate liquidity management focuses on meeting both expected and unexpected cash flows as well as collateral obligations (Clayman, Fridson, and Troughton, 2012). Corporates view liquidity management as a means for sustaining cash flow, which can shape or distort investments following mismanagement. In addition, the use of divided policy has become effective in the short-term particularly for corporates targeting complex investment options (Spaliara, 2009). Evidently, all corporates work align portfolio liquidity profile and emerging cash flow demands to avoid a liquidity squeeze.

One of the compelling reasons for inventing sustainable corporate liquidity management is to lessen the effect of financial constraints. The existence of financial constraints restricts access to capital that corporates need to meet significant internal and external obligations. In accordance with Keynes (1936), the importance of having consistent access to capital makes senses when constraints emerge in the market. The global financial crisis of 2008-2009 cemented the need for corporates to understand the influence of financial constraints. The financial crisis did not stop unending demand for loans, sustainable interest rates, profit planning, and cash flow funding situation (Garcia-Appendini and Montoriol-Garriga, 2013). Corporate managers must have the will and capacity to meet financial needs even in restricted situations to avoid lowering the liquidity and subsequent likelihood of solvency. Highly volatile markets remain a challenge to corporates without watertight and efficient liquidity management policies. The likelihood of failing to meet cash flow expectations and requirements of funds is high. According to Soprano (2015, p.104), managing illiquidity is an undesirable attribute for a corporate seeking to maintain its position during economic fluctuation and related constraints.

Almeida et al. (2014, p.135) found that corporates carry out liquidity management programs because they understand the inevitable relationship between financial constraints and firms liquidity. The review further established that liquidity policies come in handy in decision-making relating to efficient future investment. Liquidity preference theory suggests that firms must consider lessening the effects of constraints to maintain a relationship with agents such as banks (Holmström and Tirole, 2011). Apparently, the relationship between financial constraints and corporate liquidity management in practice as well research. However, few studies have concentrated on the influence of financial constraints on the liquidity management to find the efforts that corporates make to continue meeting cash or collateral obligations during financial crisis.

The study aims at putting the influence of financial constraints on corporate liquidity into proper perspective. The findings of the study will assist corporates streamline liquidity policies and avoid solvency in the event of financial constraints. Understanding the degree of effect of financial constraints on corporate liquidity would help managers to acknowledge the essence of consistent cash and finance management, which affect administrative operations as well as future investments. Thus, the paper will focus on finding out the influence of various financial constraints on the corporate liquidity management.

Seeking Investment Efficiency

Constrained firms understand the role of cash savings flows in securing future investments (Duchin, 2008). An optimal liquidity management program for constrained firms entails seeking a balance between current profitability and future investments. Some corporates choose to trade-off current valuable investments in readiness for prospects to reduce the sensitivity of cash show to financial constraints. A study by Duchin (2008) acknowledged the traditional focus of liquidity management on investment but challenged firms to consider emerging risk associated with external capital markets. Corporations must sustain positive cash flow sensitivity of cash despite financial constraints if they purpose on achieving investment efficiency.

Attaining investment efficiency becomes critical for liquidity management units in corporations that aim to secure short and long-term prospects. According to Riddiough and Wu (2009, p.448), cash-constrained firms can use the investment to measure financial market frictions that would affect cash flow management. The argument implies that constraints influence the retention of cash flow, which has the capacity to impede or accelerate valuable investments. Riddiough and Wu (2009) used a Kaplan-Zingales technique to measure the degree of financial investments where they found the inevitable relationship between investment and consistent liquidity management policies. In addition, financially constrained firms experience both high and low investment depending on the adopted liquidity management policies

Corporates adopt an active working capital management to ensure that liquidity levels sustain the current and future investments. Firms understand the extent financial constraints can affect fixed investments due to high cash flow sensitivity. Consistent working capital management uses the regime of financial constraints severe restrictions on external financing. In a study that assessed over 116,000, Ding, Guariglia, and Knight (2013) found that firms juggled between high and low investment rates to accommodate the ever-changing external financial constraints that impediment investment management. The researchers concentrated on the 2000-2007 period, which was before the occurrence of 2008 crisis. The findings emphasized on the positive influence of financial constraints on liquidity management, where the studied firms opted to use the active working capital to prevent from cash burn out. The strategy sustained the operations of the Chinese firms in the 2008 financial crisis (Ding, Guariglia, and Knight, 2013). The Chinese context provides a revelation of how corporates seek to alleviate constraints during crisis to prevent distortion of high fixed investment levels. The adjustment of working capital maintains the growth rates of the corporates, which cements the intent of any corporate liquidity management framework.

The 2008 crisis had a significant effect on corporate investment, which remains an unexplored negative shock for financial and non-financial corporates. Duchin, Ozbas, and Sensoy (2010) assessed the effect of 2008 financial crunch and found a significant decline in the investments from the onset of the crisis. While some firms make considerable forecasting, the investment opportunities vary with time and the prevailing economic circumstances. Adjusting the liquidity management policies becomes an integral part of financial planning. Duchin, Ozbas, and Sensoy (2010, p. 426) found that some firms had low cash reserves, high net short debt and high dependency on external financing due to financial constraints. The side effects of financial constraints become apparent when access to capital markets becomes limited while the chances for corporate investments decline (Spaliara, 2009). A precautionary savings motive is necessary for firms that seek to utilize cash before, during, and after the crisis.

Maintaining Cash Forecasting Consistency

The daily demand for cash in corporate supply chains begins to make sense when financial constraints lessen the external access to capital. The primary purpose of cash forecasting is to replenish the supply chain during constrained situations to sustain the capacity of firms to meet cash and collateral obligations. According to Wagner (2010, p.377) forecasting is a practice for both small and large corporates who make diverse cash management every. However, the sustaining consistency in the supply is necessary when a firm anticipates financial constraints. Wagner (2010), acknowledged cash supply chains as autonomous liquidity factors, which demands high accuracy for firms that aim at containing inevitable economic fluctuations. Cash forecasting remains a core requirement for corporate managers seeking liquidity management solutions during the financial crisis.

Correspondingly, Camerinelli (2010) found that the significant role of cash forecasting in the management of working capital is the foundation of liquidity management, particularly during the financial crunch. The study insisted that corporate shareholders and investors demand functionality irrespective of the prevailing conditions, which is a universal occurrence in small and large sized corporates. Camerinelli (2010) argued that corporates should take advantage of relevant technology to manage cash, working capital, and overall liquidity to sustain internal and external solutions. Cash forecasting becomes easier with the deployment of appropriate technology, which makes it easier for firms to make proper predictions for local, regional, and global markets.

A study of eight UK SMEs by Ekanem (2010) confirmed that financial constraints have become industrial norms, which compel corporate managers to gain a learning perspective on how to forecast cash flow while incorporating the role of external advisors. The study highlighted that policy making process must consider new networking opportunities guided by consistent forecasting efforts to ensure survival and financial well-being of corporates. In addition, the assessment of customers, suppliers, and creditors during restricted periods comes in handy in the cash flow management to inform managements about the nature of borrowing and lending they should adopt.

Creation of Cash Flow Balance

The relationship between financial constraints policies demands the creation of a balanced cash flow system. The performance of financial management determines the extent a liquid balance sheet will support sustenance of valuable projects. Almeida, Campello and Weisbach (2004, p.1777) found that creating a cash flow balance gives corporates an added advantage irrespective of the constrained conditions. The study evaluating manufacturing firms operating in 1971-2000and found the systematic balance of cash flow creates a robust liquidity balance sheet while giving liquidity management unit the access to external capital markets. The relevance of creating a balance cash flow system is to avoid distorting future investment prospects. Traditionally, firms have concentrated largely on the corporate investment demand instead of evaluating on all liquidity management aspects, which financial constraints influence considerably.

Additionally, Faulkender et al. (2012, p. 632) argued that leveraging cash flow balance affects the targeted lenders, borrowers in the external capital markets. The study acknowledges the effect of financial constraints on market timing variables, which compels firms to consider leveraging their financial targets to maintain cash flow within the supply chains. The cost of adjusting is important during constrained situations because corporates consider profitable investment opportunities and the ability to access capital market consistently. Maintaining a balance helps firms come up with appropriate liquidity policies for raising or distributing external funds (Faulkender et al., 2012). The principal goal of corporate liquidity management is issue securities or price assets to avoid costs when firms are facing financial constraints.

The cash flow sensitivity to financial constraints demands that the sources of cash must be equal to cash utilized for valuable projects or administrative expenses (Gatchev, Pulvino, and Tarhan, 2010). Corporate liquidity management incorporates a multi-dimensional approach to ensure that financing and investment go hand in hand. Managers understand that lack of balance during constrained periods lead to cash flow shortfalls, which could demand consistent but risky borrowing for meeting collateral obligations.

Meeting Collateral Obligations

Corporate liquidity management incorporates strict collateral obligations guided by the financial and risks of financial constraints. Constrained firms use the limited access to external capital as an opportunity to revise policies for meeting future investment obligations. Rampini and Viswanathan (2010, p.2293) understand the effects of collateral constraints when they review its influence in debt capacity. The study revealed that meeting collateral obligations takes priority for firms with less internal funds. Conserving the debt capacity may reduce the ability of firms to secure future investment opportunities (Araújo, Schommer, and Woodford, 2015). Evidently, financial or collateral constraints push firms to consider using risk averseness in liquidity management approach, which would increase commitment to borrowing to meet cash needs. Financial innovation becomes important for firms that seek to collateralize claims to survive restricted access to capital.

Correspondingly, Fabbri and Menichini (2010) concurred that financially constrained firms consider meeting collateral obligations using diverse methods including delaying payments. Cheaper alternative sources of funding become necessary for firms that aim at sustaining relationships with the suppliers of credit. Trade credit is a common tool for firms facing borrowing constraints despite being more expensive than bank loans (Fabbri and Menichini, 2010). The argument implies that collateral obligations mean that corporates should consider credit rationing to main high liquidity levels and the level of internal credit. Attaining flexibility in the corporate liquidity management increases a firm’s considerations of capital structures and pay out policies that align with the demand for collateral particularly when investment is at risk (Denis, 2011).

Corporates Focus On Cash Holdings

Lins, Servaes and Tufano (2010, p.161) argue that liquidity management should comprise of a clear cash holding policy. The argument emerged from a survey of firms from 29 countries to show the important of cash holding in the corporate liquidity for constrained firms. The research showed that diverse liquidity sources guard corporates against cash flow shocks during constrained periods. The essence of maintaining credit line sustains cash holding to give corporates the capacity to exploit investment opportunities after alleviating constraints (Liu and Mauer, 2011). Globally, companies understand the relationship between cash flow and sensitivity hence the need for sufficient cash holding to carry out operational as well as non-operation activities. The cash reserves have increased over time between 2008 and 2013 in major economies in response to 2008 financial crisis as shown in the graph below:

Graph 1: Cash reserves records in major economies in 2008-2013 (Deloitte University Press, 2014)

Correspondingly, corporates have exhibited varying but increasing compound annual growth rates in the period 2008-2013 as shown in the graph below:

Graph 2: Compound annual growth rates in 2008-2013 2013 (Deloitte University Press, 2014)

The essence of sustaining corporate cash holdings is to maintain financial strengths during constrained periods. Fresard (2010) provided evidence from U.S intra-industry data of 1971-2005, which showed how firms respond to financial constraints. The study demonstrated that firms must retain cash holdings to maintain significant market share. The findings imply that corporate liquidity management transcends investment, financial strength, and market shares during constrained conditions. Seeking policies of deterring the consequences of financial constraints takes a strategic dimension when firms face significant competition in the corporate market (Bates, Kahle, and Stulz, 2009). Fresard (2010) further established that cash holdings drive liquidity, but U.S firms used their cash reserves to alleviate constraints and competition in the market.

Conclusion

Evidently, financial constraints influence corporate liquidity management positively. Corporates consider sustaining their liquidity levels to access external capital markets to meet cash or collateral obligations. The paper has evaluated existing literature and found that corporate liquidity management as an extensive multi-dimensional matter for corporates as summarized in the chart below.

Figure 3: Multi-dimensional aspects of liquidity management

Therefore, financial constraints increase the need to undertake cash forecasting due to desire to sustain consistency in the corporate supply chain. Replenishing the supply chains helps to anticipate and alleviate the consequences of financial constraints. The increasing economic fluctuations require a liquidity management approach that maintains the functionality of a corporate guided by the demand from investors and shareholders. Additionally, cash flow balance is critical for firms that operation in volatile markets. Sustaining an effective liquidity balance sheet gives corporates consistent access to capital markets to avoid operational distortions emanating from financial constraints.

Liquidity management comprises of strategies for maintaining equality between administrative and investment operations among constrained firms. Conversely, a focus on cash holdings makes sense during financial crisis considering the risks of cash flow shocks that corporates might face. Financial constraints push firms to meet collateral obligations guided by adjusted liquidity policies, which prioritize on retain internal reserves and increasing borrowing capacity. Investment efficiency is the most significant influence of financial constraints on liquidity management for corporates that aim at maintaining commitments to current and future investments. Financial constraints compel corporates to rethink their liquidity management, which increases the capacity to meet emerging cash or collateral obligations.

Reference List

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Duchin, R., 2008. Cash holdings and corporate diversification. Los Angeles, California: University of Southern California.

Duchin, R., Ozbas, O. and Sensoy, B., 2010. Costly external finance, corporate investment, and the subprime mortgage credit crisis. Journal of Financial Economics, 97(3), pp.418-435.

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Appendix

Data used to generate graphs 1 and 2

Source: Deloitte University Press (2014)