QM7 Applied Econometrics Project

Poushal Gopaul

SECTION 2
2.1 Introduction
Corporate cash holdings has been a subject of attention of the US Congress1, the financial
press2 as well as finance academics. The aim of this paper is to add to the current understanding as
to why some firms are holding high levels of cash by using Compustat data on US firms from 1970
to 2008. Additional data on management entrenchment and lines of credit is used to augment the
analysis. We find that leverage has a non-linear relation with cash holdings, that lack of lines of
credit lead to increases in cash holdings and that there are adjustment costs to achieving the
target cash ratio. We report that those adjustment costs are lower in the US than in the UK and
Switzerland. The rest of this paper is structured as follows: In Section 2, we lay out the theory and
document the contribution of past research in the domain. We develop hypotheses which we test
in Section 3. In the latter, we discuss our methodology, results and conclude.

2.2 Theory and Literature Review

Interest in US firms holding beyond optimal cash holdings is not a recent phenomenon.
Opler et al (1999) document the tensions between investors and Chrysler over excessive cash
resulting in the latter agreeing to a $7.5 billion share repurchase and dividend payment
programme to return the excess liquidity to shareholders. The financial crisis magnified the
attention of the public and politicians on the ostensibly record high cash holdings of American
firms. For instance Barack Obama appealed to big corporations to invest in positive NPV projects
using their cash holdings to help the recovery of the economy. The US Congress are keen on the
US Infrastructure Bill which will grant companies a tax holiday on repatriated cash.3 Much of the
clamour on excessive cash holdings however comes from the buying side of the market. Investor
activism on this topic can be best illustrated using the case of Apple. The company had on its
balance sheet around $150 billion dollars at the end of March 2013. It was rational of investors to
question those figures given that the return on cash is equal to or below the risk free rate of return.

1.

Obama Will Tell Chamber Businesses to Put Cash to Use for Jobs, by Mark Drajem and Mike Dorning,
BusinessWeek, February 7, 2011

2.

The Financial Times reports the concentration of cash piles among few companies. Huge cash pile puts
recovery in hands of the few, by Anousha Sakoui, Financial Times, January 21, 2014

3.

US infrastructure bill targets companies overseas cash, by Chon Gina, Financial Times, January 27, 2014

4.

CNBC Squawk Box, February 7, 2013.

QM7 Applied Econometrics Project

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If Apple had cash in excess of its needs, investors demanded the cash to be distributed via share
repurchases and dividend payments. Legendary hedge fund manager David Einhorn went as far as
to compare Apples conservative mentality to his depression-scarred grandmother, someone
whos gone through traumas they sometimes feel they can never have enough cash.4

The follow up questions that the practitioners of finance are requiring from the academia
is how to evaluate whether a firm is holding excessive cash holdings, why firms are holding those
levels, what is the value of this cash and is this high cash holdings environment the new normal.
Empirical evidence has brought up some potential answers to those questions. The starting point
of this discussion is to understand that demand for cash by firms arise because of market frictions.
In a frictionless world, rational behaviour dictates that no firm would hold cash other than that
required for working capital purposes. The classic paper Modigliani and Miller (1958) argue that in
such an environment, companies can fund all value-increasing investment opportunities.
Therefore there is no optimal level of cash and the marginal value of a dollar in cash for
shareholders should be exactly one dollar (Bates et al, 2011). In a perfect information setting, a
firm with a positive NPV project can raise funds through external sources such as debt or equity
issue if internal funds are insufficient. It will do so at prices which reflect fundamentals and at no
transaction costs. However the reality is that frictions are sufficiently strong to lead to cash
holdings. Some frictions that are likely to incentivise holding cash are transaction costs (Miller and
Orr, 1966), agency problems (Jensen, 1986) and asymmetric information between investors and
managers and uncertainty in the future (Myers and Majluf, 1984). Bates et al (2009) document a
secular increase in average cash holdings by non-financial US firms across all firm sizes from 1980
to 2006. Our sample also shares the same upward trend in mean and median cash ratio as shown
in Figure 1.

Given the market imperfections mentioned above, the demand for cash becomes
apparent. The current literature on cash holdings emphasises three main motives for holding cash;
the transaction cost motive, the precautionary motive and the agency motive. The former builds
on the framework of Miller and Orr (1966) and makes the point that firms facing low internal
resources can raise funds by selling assets, issuing new equity through seasoned equity offerings,
issuing debt or by cutting dividend payments. However because of fixed and variable costs
involved in those strategies, there is likely to be some benefit of holding cash. A testable
hypothesis from this model goes as follows: large firms will incur lower average transaction costs
2

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Poushal Gopaul

per dollar raised because of economies of scale and therefore one would expect cash holdings as a
percentage of total assets to decrease as the size of a firm increases. Mulligan (1997) finds that
large firms hold less cash as a percentage of sales than small firms consistent with transaction
motive. The precautionary motive of cash holdings (Keynes, 1936) posits that firms hold cash as a
cushion to protect themselves against negative micro- and macro-economic shocks. This theory
predicts that firms in riskier industries with high cash flow and sales volatility will hold more cash.
Opler et al (1999) provide evidence that non-financial US firms facing more uncertainty hold on
average more cash.5

Figure 1. Average and median cash ratios from 1970 to 2011. The sample includes all Compustat firm-year observations
from 1970 to 2011 with positive values for the book value of total assets and sales revenue for firms incorporated in the
United States. Financial firms (SIC code 6000-6999) and utilities (SIC codes 4900-4999) are also excluded from the
sample. The cash ratio is measured as the ratio of cash to the book value of total assets.

The agency motive for cash holdings (Jensen, 1986) stems from the fact that there is a separation
of ownership in corporations. Managers (the agents) are likely to have conflicting goals than that
of their shareholders (the principle). For e.g. managers may be more interested in empire building,
expensive perquisites and reluctance against takeover rather than in increasing the value of
shareholders wealth. Manager ownership is a measure designed to align the incentives of the
managers with that of shareholders. Managers are less likely to hoard cash from profitable

5.

Empirical support of the precautionary motive can be found in Almeida et al (2004), Acharya et al (2007), Bates
et al (2009), Han et al (2007), Harford et al (2008) and Haushalter et al (2007).

QM7 Applied Econometrics Project

Poushal Gopaul

projects as they share part of the costs of their actions. However excessive manager ownership is
likely to lead to management entrenchment. Outside investors find it more difficult to monitor the
actions of the managers and managers have greater ability to withstand proxy contests la Icahn.6
Ozkan and Ozkan (2004) find support for this non-linear relationship between manager ownership
and cash holdings in a sample of 839 UK firms from 1984 to 1999. In addition, Stiglitz (1985)
argues that firms with dispersed shareholders and no blockholders are likely to hold larger
amounts of cash because the costs of monitoring will be prohibitive. Kusnadi (2004) analyses
Singapore firms and reports a significant positive relationship between outside blockholders and
cash holdings. A widely used measure of management entrenchment and by extension
shareholder rights is the Gompers, Ishii and Metrick index (2003). The G index is a cumulative
index of 24 takeover governance provisions. The index is constructed in such a way that a high G
index value means the firm has more entrenched management and this results in the testable
hypothesis that firms with higher G value should have more cash holdings than firms with lower G
value.

Myers and Majluf (1984) suggest that asymmetric information between managers and
investors cause the latter to ask for a higher than fair rate of return on funds invested. This is
consistent with the pecking order theory of corporate structure which emphasises that firms will
use internal funds first to finance projects and resort to debt issue if there is not enough internal
funds. At the last resort, the firm will issue equity because the latter is more informationally
sensitive and more likely to be mispriced. Therefore, firms associated with more information
asymmetries will hold more cash than the average firm because they will have to pay a higher
premium on external financing. Such firms have been identified as firms with high growth
opportunities (Tobins Q), firms with high expenditure on research and development as a
percentage of total assets and firms which do not have debt and commercial paper ratings. Bigger
firms generally exhibit less information asymmetries because external monitoring may be stronger.
Therefore firms with larger total assets may hold less cash than smaller firms, which reinforce the
transaction cost hypothesis about firm size mentioned earlier. Bates et al (2009) and Drobetz
(2006) provide empirical evidence of the effects of information asymmetries on cash holdings on
US firms and Swiss firms respectively.

6.

TWA Death of a legend, by Elaine Grant, St Louis Magazine, October, 2005

QM7 Applied Econometrics Project

Poushal Gopaul

Another branch of this literature studies the relationship between share issuance and cash
holdings which result from the proceeds of the public offering. Blanchard et al (1993) posit that
market timing share issuances result in high share issuancecash savings. The premise of this
argument is that firms want to take advantage of favourable conditions to raise finance and not
necessarily to finance profitable projects. Therefore, when the equity price is overvalued,
managers will seek to issue shares to capture the overvaluation. However, as more information
comes to the disposal of investors the price of the stock adjusts to the lower level suggested by its
fundamentals. Therefore, the stocks of firms which save more out of share issuance should
underperform following the underwriting exercise. For instance, Kim et al (2008) find that the
bulk of inflows from seasoned equity offerings and initial public offering are not used for
investments but rather is kept as cash. McLean (2011) finds that the amount of issuance resulting
in cash savings by US firms has increased threefold compared to the 1970s. At the same time,
proxies for precautionary motive has increased over the period covered in the sample, suggesting
the increase in cash savings from issuance are attributed to the precautionary motive. McLean
(2011) also has empirical evidence that share issuance costs can be a cause of high cash holdings
but does not find support for the market timing argument.

The literature emphasises on the role of financial constraints and cash substitutes to
explain the variation in cash holdings among firms. We argue that the financial sector (Wall Street)
can impose financial constraints on the real sector (Main Street) by reducing the amount of loans
provided and increasing credit assessments criteria. Therefore, if firms are unable to get loans
easily this should result in firms increasing their cash holdings so as not to miss out on profitable
projects. For e.g. Warren Buffet views cash held in his portfolio as a call option allowing him to
acquire assets at fire sale prices (such as his $5 billion investment in Goldman Sachs during the
depths of the financial crisis).7 Greater competition in the banking sector will lead to a fall in credit
assessment criteria as bankers attempt to get more of the market and firms will require less cash
holdings. This follows from the work of Cetorelli (2004) who establishes that market power gives
banks an implicit equity stake in the firms in which they fund and market power can also act as a
financial barrier to entry to firms. Pinkowitz and Williamson (2001) support the view that strong

bank power is the reason why Japanese firms hold twice as much cash holdings than US and
German firms. Another substitute for cash implied in the literature is leverage. Baskin (1987)

7.

For Warren Buffett, the cash option is priceless, The Globe and Mail, September 24, 2012.

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argues that the cost of cash increases as the ratio of debt financing increases, which would result
in a fall in cash holdings as a firm levers up. This results in the testable hypothesis that there
should be a negative relation between a firms cash holdings and its gearing ratio. Bates et al
(2009) and Opler et al (1999) verify this among US firms. However we argue that as a firm reaches
very high levels of leverage there is an increased probability of financial distress and incurring its
costs. Therefore to hedge against this event, we expect firms with high debt ratio to increase its
cash holdings. This results in a positive relation between cash holdings. We model our regression
to take into account the non-linearity of leverage. The non-monotonicity of this relationship can
be graphed as follows:

Cash ratio

Leverage ratio
Figure 2: Non-linear relationship between cash holdings and leverage

Another substitute effect studied in the literature is working capital net of cash. Such
items include inventory and debt and other receivables. These are very liquid assets and can be
readily converted into cash should the need arise. This results in a negative relation between cash
and working capital net of cash. We contribute to the literature by studying the effects of another
likely cash substitute: lines of credit. Lines of credit are often extended by banks to creditworthy
customers to address liquidity problems. We suggest that firms which do not have a line of credit
will tend to hold higher cash holdings that the average firm. The presence of a line of credit can
also be viewed as a measure of financial constraint. Sufi (2009) provides evidence that lack of
access to a line of credit is a statistically powerful measure of financial constraints. Following
Ozkan and Ozkan (2004), we study cash holdings in a dynamic setting. Ozkan and Ozkan (2004)
find that adjustment costs do matter for firms in the UK. We provide further details in the section
concerned.

QM7 Applied Econometrics Project

Poushal Gopaul

SECTION 3
3.1 Foreword
The theoretical analysis in the previous section generates testable empirical implications
between a firms cash holdings and firm characteristics. In this section, we examine the
relationship between firm characteristics and cash holdings and study whether the relationship
changed over time. We start by describing our data and our sample construction. We present the
theoretical rationale behind our analysis when appropriate. We present and comment on the
implication of our regression results. We also carry out robustness tests to check the validity of our
results.
3.2 Data and sample construction
For our empirical analysis of the determinants of cash holdings, we use a panel data of US
non-financial firms from 1970 to 2011 obtained from the Compustat database. We exclude
financial firms (HSIC code 6000 6999) and utilities (4900 4999) because those industries are
regulated and have cash requirements which are exogenous of firm characteristics. We also drop
firm-year observations for which variables used in our model is missing. These criteria have
provided us with an unbalanced panel of unique 10,678 firms, which represents 116,595 firm-year
observations. Summary statistics on the sample reveal possible outliers in our variables and we
carry out the winsorisation procedure on accounting variables at the 1 % level. We use total
assets to scale our variables unless specified otherwise and convert the size variable using 2008 as
our base year to remove the effects of inflation on total assets.

In addition to Compustat firm-year observations, we use data available on the Federal

Deposit Insurance Corporation website to construct a rough measure of credit constraint. We
construct this variable by dividing the net loans and leases by total assets held by all financial
institutions insured by FDIC. We argue that a fall in this variable implies that banks are less willing
to provide funds to firms which then hold more cash. We can also interpret this variable as a
measure of competition in the banking sector, in the absence of more developed measures such
as the Herfindahl index. We also augment our sample by merging our sample with the database on
lines of credit provided by Sufi (2009). Details about variable construction and direction of effects
are shown in Table 1.

QM7 Applied Econometrics Project

Poushal Gopaul

3.3 Static Panel Data Analysis (Pooled OLS, Fixed and Random Effects and Fama-MacBeth
Regressions)
Because additions in our sample drastically reduce the number of observations in our
sample, we proceed by studying more general models first and introduce our additional variables
afterwards. Our baseline model is of the following form:
, = 1 , + 2 &, + 3 , + 4 , + 5 ,
+ 6 , + 7 , + 8 2 , + 9 ,
+ 10 , + 11 , + 12 , + 13 ,
+ 14 + 15 + + + ,

Table 1: This table details how we constructed our independent variables and explains the theoretical relationship
between the variable and cash holdings
Independent
Formula
Expected sign
Variable
Positive as high market to
(Book value of assets - book value of equity + the
book value proxies for
1
Market to book value
market value of equity)/
greater information
Book value of assets
asymmetry.
Positive as firms with higher
2
R&D
R&D/Book value of assets
R&D are more financially
constrained.
3
Capital Expenditure
Capital Expenditures/Book value of assets
Positive if viewed as proxy
for financial distress.
Negative if viewed as
4
Acquisitions
Acquisitions/Book value of assets
collateral to secure loans.
Positive as firms with high
(Earnings (Interest +Dividends,
cash flow accumulate more
5
Cash Flow
+Taxes) + Depreciation)/Book value of assets
cash. Negative if cash flow
seen as substitute of cash.
Negative as net working
6
Net working capital
Net working capital Cash)/Book value of assets
capital can be used in place
of cash.
Negative if leverage seen as
cash substitute.
(Long-term Debt + Short-term Debt)/ Book value of
Positive as firms with high
7
Leverage
assets
levels of leverage face high
probability of financial
distress.
Positive as more volatility
Industry Cash Flow
Compute
cash
flow
standard
deviation
for
past
10
means firms will hold more
8
Volatility
years and average across 2 digit HSIC code.
cash under the precautionary
motive.
Negative. Larger firms are
less financially constrained
9
Size
Logarithm of book assets deflated to 2008 prices.
and more externally
monitored.
Negative. Dividend paying
Takes the value of 0 if firm does not pay dividend in
10
Dividend Dummy
firms can reduce dividend if
that fiscal year, 1 otherwise.
they face a cash shortfall.

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Independent
Variable

Formula

Asset Tangibility

Property, plant and equipment/book value of assets.

Banks Loan to Asset

Ratio

Financial Crisis
Dummy

Net loans and leases by all financial institutions/Total

Assets of all financial institutions

Takes value of 1 for observations after 2007, 0

otherwise.

Z = 1.2*WC + 1.4*RE+ 3.3*EBIT + 0.6*MVBV +

0.999*SALES

14

zscore

where
WC = Working Capital / Total Assets.
RE = Retained Earnings / Total Assets.
EBIT = Earnings Before Interest and Taxes / Total
Assets.
MVBV = Market Value of Equity / Book Value of Total
Liabilities.
SALES = Sales/ Total Assets.

Expected sign
Negative. PPE can be used as
collateral and reduces
financial constraints.
Negative. This proxy for
liquidity from banks. A higher
value means loans are easily
available and hence cash
holdings are not as valuable.
Positive. Uncertainty
increased after the financial
crisis and precautionary
motive predicts an increase
in cash holdings.

Positive.
A positive relationship can
reflect the fact that firms in
financial distress hold less
cash.

A positive relationship can

also imply that financial
pressure reduces the agency
costs of free cash flow.

We use Cash to Total Assets as our dependent variable following Bates et al (2009). Model
(1) reports the pooled OLS regression with robust standard errors. We adjusted for
heteroskedasticity after the White test rejected the null hypothesis of constant variance. Briefly
the White test regresses the squared residuals from the original regression model onto a set of
regressors that contain the original regressors, the cross-products of the regressors and the
squared regressors. The effects of our regressors on cash holdings are consistent with the above
theory. Asset tangibility and net working capital have the highest effects on cash holdings.
Therefore a possible explanation of the rise in cash holdings is that firms are holding a lower level
of physical asset to total assets and have lower net working capital. Net working capital is made up
of inventory and debt receivables. We suggest that stock control and debt management may have
caused this reduction. The significant negative coefficient on the Bank loan to asset ratio suggests
that the financial sector has a role in the determination of firms cash holdings. We are concerned
however about the non-normality of the cash ratio as shown in Figure 3. This motivates our use of
the logarithm of cash/assets as our dependent variable in Model 2. The scaling change alters the

QM7 Applied Econometrics Project

Poushal Gopaul

magnitude of our coefficients but the signs are unchanged except for the coefficient of Cash Flow
which becomes positive implying that firms with higher cash flows have higher cash holdings.

Figure 3: Histogram of cash ratio and natural logarithm of cash ratio. The histograms were drawn using Compustat
firm-year observations from 1970 to 2011 with positive values for the book value of total assets and sales revenue for
firms incorporated in the United States excluding financial and utilities firms. The cash ratio is measured as the ratio of
cash to the book value of total assets. A normal distribution graph is overlaid on the histogram to highlight departures
from normality.

We use the fact that our sample is a long panel data which will enable us to take into
account firm and year heterogeneities. Model 3 reports fixed effects regression controlling only
for firm heterogeneity and Model 4 reports fixed effects regression with both firm and year fixed
effects. To test whether using year fixed effects add to the robustness of our results, we run an F
test on the year dummies. The F statistic is calculated as follows:
=

( )/
/( 1)

where RSS is the residual sum of squares with subscript R denoting the restricted model and UR
denoting the unrestricted model. The q stands for the number of restrictions which in this case is
the number of year coefficients and (n-k-1) is the degrees of freedom. The null of the F test is that
the year slopes are jointly equal to zero and with an F statistic of 20.24, we reject the null and
conclude that there are time fixed effects. The coefficient of Capex and Size flip signs with the
introduction of time fixed effects. The negative value of the coefficient on Capex is consistent with
the collateral argument. Likewise, a larger firm may have a higher cash holdings because of the
scale of its operations. We also estimate a random effects model (Model 5) which assumes that
the firm specific effect is a random variable that is uncorrelated with the explanatory variables.
year fixed effects and the random effects, we run a Hausman test where the null hypothesis is that

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QM7 Applied Econometrics Project

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errors are not correlated with the regressors in which case the random effects is the preferred
model. The Hausman test statistic is calculated as follows:
2 =

2 ( )2
(, )2

where 2 is the residual variance from the fixed effects model and ( ) is the difference
between the obtained from the fixed effects model and the random effects model. With a chisquared value of 3578.15, we reject the null and maintain FE as our preferred model.

For completeness, we run a Breusch-Pagan Lagrange multiplier test to choose between

the random effects model and the pooled OLS model. The null hypothesis is that the variances
across entities are zero and therefore there is no panel effect in which case the pooled OLS is the
better model. The Lagrange Multiplier is obtained through the following procedures. First we
regress the random effects model to obtain the residuals with which we construct an auxiliary
regression with the residuals squared as dependent variable. We then calculate the LM statistic as
nR2 with n being the number of observations and R2 is obtained from the auxiliary regression.
We reject the null with a chi squared value of 58011.41. In summary, the RE model is better than
the OLS model but is not consistent compared to the FE model. Models 6, 7 and 8 report FamaMacBeth regressions analysing how the relationship between firm characteristics and cash
holdings changed over the last three decades. Compared to the 1980s, we see an increasing
demand for cash holdings due to increased volatility in industry cash flows and for non-dividend
paying firms. Across all our models, the coefficient of zscore which is a proxy for the probability of
financial distress is positive. This is consistent with the findings of Kim et al (1998) who argue that
firms with higher probability of financial distress hold less cash. We can also use the Jensen (1986)
argument that as firms face financial pressures, this reduces management entrenchment and
therefore reduce the agency costs of free cash flow. Moreover, we note that all of our regressions
support the non-monotonicity of leverage as the coefficient of Leverage is consistently negative
while the coefficient of Leverage2 is consistently positive. We conclude that this is evidence that as
leverage reaches a certain point the probability of default outweighs the substitution effect of
leverage.

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Table 2: The sample includes all Compustat firm-year observations from 1970 to 2011 with positive values for the book value of total assets and sales revenue for firms incorporated in
the United States. Financial firms (SIC code 6000-6999) and utilities (SIC codes 4900-4999) are excluded from the sample. The fixed effects and random effects regression excludes firms
that have gone public in the past 5 years. Standard errors robust to clustering by firm and year are reported in parentheses for the OLS regressions. Standard errors in the Fama-MacBeth
regressions use Newey and West (1987) standard errors to control for autocorrelation. We report average R squared instead of adjusted R Squared for the Fama-MacBeth regressions.
Model
Expected sign

Dependant
Variable
Market to Book
Value
R&D

Capital
Expenditure
Acquisitions

Cash Flow

Cash Flow
Volatility
Net Working
Capital
Leverage

+/-

+/-

+/-

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

OLS

OLS

Firm Fixed
Effects

Firm and Year

Fixed Effects

Random Effects

F-M (1980s)

F-M (1990s)

F-M (2000s)

Cash/Assets

Log(Cash/Assets)

Cash/Assets

Cash/Assets

Cash/Assets

Cash/Assets

Cash/Assets

Cash/Assets

0.0263***

0.113***

0.0173***

0.0191***

0.0232***

0.0183**

0.0129**

0.0264***

[0.00196]

[0.00469]

[0.00261]

[0.00259]

[0.00261]

[0.00421]

[0.00275]

[0.00319]

0.0562***

0.129***

0.0147***

0.0151***

0.0353***

0.413***

0.154*

0.0669***

[0.00236]

[0.00562]

[0.00412]

[0.00412]

[0.00338]

[0.0345]

[0.0518]

[0.0120]

0.0630***

1.434***

-0.00134

-0.0175

0.0105

0.0346*

0.0758*

-0.0603**

[0.00911]

[0.0743]

[0.0114]

[0.0117]

[0.0109]

[0.0137]

[0.0288]

[0.0174]

-0.287***

-0.725***

-0.171***

-0.167***

-0.172***

-0.112***

-0.232***

-0.355***

[0.00935]

[0.0804]

[0.0105]

[0.0105]

[0.0100]

[0.0196]

[0.0164]

[0.0283]

0.0420***

0.357***

0.240***

0.238***

0.173***

0.183***

0.121***

0.0198

[0.00868]

[0.0323]

[0.0124]

[0.0123]

[0.0112]

[0.0240]

[0.0119]

[0.0158]

0.446***

1.568***

-0.931***

-0.125

0.523***

0.340*

0.987***

0.898***

[0.0344]

[0.199]

[0.0782]

[0.0885]

[0.0731]

[0.135]

[0.135]

[0.0661]

-0.401***

-2.514***

-0.386***

-0.404***

-0.426***

-0.443***

-0.423***

-0.447***

[0.00480]

[0.0242]

[0.00997]

[0.00982]

[0.00866]

[0.0130]

[0.0112]

[0.0178]

-0.746***

-6.094***

-0.451***

-0.459***

-0.540***

-0.632***

-0.792***

-0.787***

[0.0143]

[0.0645]

[0.0213]

[0.0212]

[0.0204]

[0.0257]

[0.0343]

[0.0281]

Continued

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QM7 Applied Econometrics Project

Dependant
Variable
Leverage2

Dividend
Dummy
Size

Z Score

Financial Crisis
Dummy
Bank Loan to
Asset Ratio
Tangibility

Constant

N
Adjusted R
Squared

Poushal Gopaul

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

OLS

OLS

F-M (1980s)

F-M (1990s)

F-M (2000s)

Log(Cash/Assets)

Firm and Year

Fixed Effects
Cash/Assets

Random Effects

Cash/Assets

Firm Fixed
Effects
Cash/Assets

Cash/Assets

Cash/Assets

Cash/Assets

Cash/Assets

0.806***

5.740***

0.483***

0.485***

0.559***

0.681***

0.876***

0.922***

[0.0180]

[0.109]

[0.0272]

[0.0269]

[0.0254]

[0.0305]

[0.0495]

[0.0426]

-0.0111***

0.00715

0.0142***

0.00803***

-0.000902

-0.00483

-0.0279***

-0.0386***

[0.000966]

[0.00820]

[0.00210]

[0.00211]

[0.00191]

[0.00323]

[0.00380]

[0.00218]

-0.0084***

-0.0475***

-0.00186

0.00730***

-0.00142

-0.0073***

-0.0047***

-0.0079***

[0.000285]

[0.00219]

[0.00168]

[0.00180]

[0.000997]

[0.000618]

[0.000642]

[0.00104]

0.00201***

0.00395**

0.00158*

0.0015

0.00160*

0.00307*

0.00430***

0.00483***

[0.000601]

[0.00125]

[0.000804]

[0.000781]

[0.000805]

[0.00130]

[0.000883]

[0.000647]

-0.0281***

-0.338***

-0.0286***

[0.00218]

[0.0155]

[0.00306]

-0.422***

-7.617***

-0.0948**

[0.0192]

[0.156]

[0.0311]

-0.312***

-2.035***

-0.473***

-0.492***

-0.442***

-0.353***

-0.324***

-0.280***

[0.00341]

[0.0271]

[0.0119]

[0.0121]

[0.00833]

[0.0142]

[0.0121]

[0.00900]

0.631***

3.461***

0.484***

0.384***

0.409***

0.394***

0.343***

0.333***

[0.0106]

[0.0861]

[0.0182]

[0.0108]

[0.00753]

[0.0130]

[0.00785]

[0.00860]

116595

116038

108287

108287

108287

27826

32656

27983

0.508

0.41

0.235

0.248

0.4721

0.4425

0.5297

0.5421

Standard errors in brackets *p<0.05,**p<0.01,***p<0.001

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3.4 Lines of Credit as a source of liquidity and interaction with risk of financial distress
In this section, we use publicly available information on lines of credit (LOC) used in Sufi
(2009) to understand the role of lines of credits on the cash holdings of firms. The existence of
lines of credit is motivated by the presence of capital market frictions. Essentially, it is an
arrangement between the bank and the firm that establishes a maximum loan balance that the
bank will permit the firm to maintain. The borrower can draw down on the LOC at any time, as
long as he or she does not exceed the maximum set in the agreement. Therefore, in this setting
cash holdings should be at its minimal if a firm has access to a LOC. In fact, Kashyap et al (2002)
and Gatey and Straham (2006) maintain that banks are the most efficient liquidity providers in the
economy. We expect a negative relationship between cash holdings and the presence of a line of
credit. Moreover, we expect that firms with high probability of financial distress are more reliant
on cash holdings in the absence of a line of credit. To test this hypothesis, we divide our sample
into two groups by using the median of the zscore as the cutting off point. Firms with Altmans
zscores higher than the median are grouped in the low financial distress risk group with the rest
being the most at risk. We run a fixed effects model similar to Model 4 of Table 1 with firm and
year fixed effects. We control for heteroskedasticity and serial correlation. The year dummies are
found to be jointly significant with an appropriate F test. The F statistic for the Model (9) is 20.91
while the F statistic for the Model (10) is 4.29. We choose not to report the random effects
regression based on the Hausman test which reveals there is no gain in efficiency by allowing
random effects on neither of the models. We also choose cash ratio over the log of cash ratio so as
for the reader to readily compare estimates with model 4. The model is as follows:
, = 1 , + 2 &, + 3 , + 4 , + 5 ,
+ 6 , + 7 , + 8 , + 9 , + 10 ,
+ 11 , + + + ,

Line of Credit Dummy is a dummy variable which takes the value of 1 if the firm has a line of credit
in that year and 0 otherwise. The coefficient of this variable can therefore be interpreted as the
difference in cash holdings between two identical firms in all aspects except for the presence of a
usable line of credit.

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Table 3: The sample includes all Compustat firm-year observations from 1996 to 2003 with positive values for the book
value of total assets and sales revenue for firms incorporated in the United States. Financial firms (SIC code 6000-6999)
and utilities (SIC codes 4900-4999) are excluded from the sample. We exclude firm-year observations for which we do
not have information on their lines of credit. This yields a sample of 21,198 observations. Firms with low probability are
identified as being greater than the median of the zscore. Standard errors robust to clustering by firm and year are
reported in parentheses for the OLS regressions. Fixed effects account for firm and year heterogeneity.
Model

(9)

(10)
Fixed Effects Regressions

Expected Sign

Dependent Variable

Firms with low probability of financial distress

Cash/Total Assets

financial distress
Cash/Total Assets

0.0222***

0.0120**

[0.00211]

[0.00461]

0.0076

0.00686

[0.00848]

[0.00792]

-0.735***

-0.213***

[0.0620]

[0.0379]

-0.363***

0.0018

[0.0415]

[0.0192]

0.407***

0.238***

[0.0412]

[0.0287]

-0.780***

-0.235***

[0.0379]

[0.0223]

-0.280***

-0.131***

[0.0404]

[0.0298]

-1.349***

0.0297

[0.285]

[0.202]

0.0855***

0.0312***

[0.00988]

[0.00604]

0.00831

-0.00226

[0.0105]

[0.00581]

-0.019

-0.0278**

[0.0102]

[0.00877]

[0.00899]

[0.00538]

0.0955

0.028

10599

10599

Adjusted R Squared

0.207

0.09

Market to book value

R&D

Capital Expenditure

Acquisitions

Cash Flow

Net Working Capital

Leverage

Cash Flow Volatility

Size

Dividend Dummy

Line of Credit Dummy

Firms with high probability of

+/-

+/-

+/-

+/-

+/-

Constant

Standard errors in brackets * p<0.05, ** p<0.01, *** p<0.001

Table 2 reports the results of those regressions on the two groups of firms. We notice that
the coefficient of the LOC dummy corresponds to the theory being negative for both types of firms.
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However, more interestingly the negative relationship is only significant among firms with high risk
of financial distress. Put in another way, firms with no lines of credit and with low zscore will tend
to save more cash holdings. A policy implication of trying to reduce corporate cash holdings would
be to ensure that firms have access to lines of credit. This finding mirrors that of Sufi (2009) who
finds that a relationship between the use of lines of credit and lagged cash flow is unique among
firms with high financial distress likelihoods. However, a quick inspection of the requirements for
the application of a line of credit reveals that our previous models may suffer from endogeneity.
The HSBC website lists the following as some of the factors considered: 1) Business track record, 2)
projected business performance, 3) projected business requirements and 4) collateral coverage.
Endogeneity occurs when the independent variable is correlated with the error term and results in
biased estimates of the true relationships. Given that financial institutions perform a credit
assessment based on the characteristics of the firm, items such as past level of cash holdings, size,
level of tangible assets and so on may ultimately determine whether a line of credit or a simple
loan is granted. Therefore in our model the problem of endogeneity arises from simultaneity. In
the next section, we tackle this problem by using instrumental variables in a dynamic setting.

3.5 Dynamic Panel Data Analysis

Figure 4: Average cash ratios of groups of firms sorted by cash ratio at 1970. The sample includes all Compustat firmyear observations from 1970 to 2011 which were present in the sample in 1970. Only firms with positive values for the
book value of total assets and sales revenue are included. Financial firms (SIC code 6000 6999) and utilities (SIC code
4900 4999) are excluded from the sample, yielding a panel of 153 unique firms. The cash ratio is measured as the ratio
of cash to the book value of total assets. Firms are sorted into deciles based on the cash ratio they held in 1970. Top
Decile refers to the firms holding the highest level of cash while Bottom Decile refers to the firms holding the lowest
level of cash in the sample in 1970.

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We motivate this next section by studying Figure 4. The graph was created by sorting firms
present in the sample in 1970 according to cash ratio into ten groups and we followed the average
cash ratio of each group over time. Survivorship in the sample is evenly spread across all groups
although the group with the highest cash ratio in 1970 has a marginally higher survivorship rate of
22% versus an average of 14%. We infer that this is due to young firms holding higher cash ratios
because they save out of their initial public offering and also will last longer in the sample. We find
that firms with the highest cash ratios tend to decrease their cash ratio over time. Conversely,
firms who had the lowest cash ratio adjust gradually to a higher level. We view this as evidence of
adjustment towards a target cash level. Opler et al (1999) establish a negative autocorrelation and
maintain that the hypothesis of firms adjusting towards a target level of cash holdings cannot be
rejected. To formalise and quantify the adjustment process, we specify a dynamic model following
Ozkan and Ozkan (2004) by adding a lag of the dependent variable as an explanatory variable.8
The model we examine is the following:
, = 1 ,1 + 2 , + 3 , + 4 , + 5 , + 6 ,
+ 7 , + 8 + + + ,

To interpret the coefficient of the lagged dependent, we assume that the target cash ratio is
determined by firm characteristics such as size, cash flow, growth opportunities and whether it
has a credit rating or not. Specifically,
, = , + ,

However because of lags in the adjustment process such as information lags, transaction costs and
other adjustment costs, , is not equal to , . We can express the adjustment process
as follows with being the adjustment coefficient.
, ,1 = ( , ,1 )
Plugging the two equations together yields the model we are studying with 1 = 1- . A value of
close to zero (1 = 1) implies that the adjustment process is very slow and adjustment costs are
expensive. However, the inclusion of a lagged dependent variable will lead to the violation of the
exogeneity assumption in both OLS and fixed effects models. The demeaning process of a fixed
effects model which is designed to take into account firm heterogeneity creates a correlation
between the regressor and the error term (Nickell, 1981). The resulting correlation biases the
8.

Drobetz and Grninger (2006) reproduce the methodology on Swiss firms and provide evidence of adjustment
costs.

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coefficient of the lagged dependent variable and most problematic is the fact that the bias does
not decrease by increasing the sample size. This motivates our use of the Generalised Methods of
Moment (GMM) dynamic panel estimator of Arellano and Bond (1991) which draws upon the
work of Holtz-Eakin, Newey and Rosen (Econometrica, 1988). The GMM method of estimation
provides consistent estimates by making use of instruments that can be obtained from the
orthogonality conditions that exist between the lagged values of the variables and disturbances of
the differenced equation. However estimation problems arise if there is higher order serial
correlation in the idiosyncratic error term. While AR(1) autocorrelation of the error term in first
differences does not affect the properties of the GMM estimator, AR(2) autocorrelation leads to
inconsistent estimators. Therefore we test for first and second order serial correlation. We also
report the statistic for the Sargan test of over-identifying restrictions (Sargan, 1958). Under the
null hypothesis that the over-identifying restrictions are valid, the statistic is asymptotically
distributed as a chi-square variable with (m k) degrees of freedom (where m is the number of
instruments and k is the number of endogenous variables). We present two versions of the GMM
model, one assuming all firm-specific variables are exogenous and one where we instrument all
the firm-specific variables. This is because we believe that it is very likely that there may be some
shocks which will affect the left hand side of our regression as well as the independent variables.

Because of limited processing power, we choose to run the Arellano and Bond GMM on a
subset of our sample and we construct the sub sample by selecting only firms for which we have
the credit rating for their debt and commercial paper. We construct a dummy which takes the
value of 1 if the firm has a credit rating whether on short or long term debt and the value of 0 if
the firm does not have any. This is conditional on the firm having debt in their balance sheet. If the
firm-year observation has zero debt, the dummy is set to . and drops out altogether when
running the regression. The presence of a credit rating can be viewed as a reduction in information
asymmetry between investors and the company. We expect therefore, controlling for other firm
characteristics, which having a debt rating will lead to a lower cash holdings because external
financing is readily available. Our two GMM regressions have broadly the same significant results
except for the zscore which loses its significance in the endogenous setting. We note that while
our two regressions exhibit AR(1) which is not problematic, they also satisfy the crucial assumption
for consistency with respect to no second order autocorrelation. However, the Sargan test reveals
that in the exogenous setting, the overidentifying restrictions are not valid whereas this is the case

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for the endogenous setting. This increases confidence in our model as it echoes the results of
Ozkan and Ozkan (2004).
Table 4: The sample includes all Compustat firm-year observations from 1970 to 2011 with positive values for the book
value of total assets and sales revenue for firms incorporated in the United States. Financial firms (SIC code 6000-6999)
and utilities (SIC codes 4900-4999) are excluded from the sample. Standard errors robust to clustering by firm and year
are reported in parentheses for the OLS regressions. Standard errors in the Fama-MacBeth regressions use Newey and
West (1987) standard errors to control for autocorrelation. We report average R squared instead of adjusted R Squared
for the Fama-MacBeth regressions.
Model

Cashi,t-1

Size

MVBV

Cash Flow

Net Working Capital

Leverage

Zscore

Credit Rating Dummy

Constant

(11)

(12)

GMM-Exogenous

GMM-Endogenous

Cash Ratio

Cash Ratio

0.260***

0.151***

[0.0198]

[0.0145]

0.101***

0.0165**

[0.00620]

[0.00517]

-0.0125

0.0136

[0.00668]

[0.00728]

0.164***

0.375***

[0.0232]

[0.0360]

-0.362***

-0.300***

[0.0169]

[0.0262]

-0.0874***

-0.132***

[0.0239]

[0.0296]

0.0131***

0.00547

[0.00313]

[0.00323]

0.0126*

0.0208**

[0.00540]

[0.00764]

-0.448***

0.0304

[0.0324]

[0.0295]

47551

47551

Arellano-Bond test for zero autocorrelation in first-differenced errors

z statistic reported (p value in brackets)
AR(1)

AR(2)

Sargan Test (df)

-15.1270

-16.28

[0.000]

[0.000]

1.5268

0.16326

[0.1268]

[0.8703]

863.9531

4231.884

[699]

[5192]

Standard errors in brackets *p<0.05,**p<0.01,***p<0.001

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From table 2, Column 2, we can see clearly that adjustment costs matter as the coefficient
of the lagged dependent variable is significant at the 1% level. This results an adjustment factor of
(1 - 0.151) = 0.849. Ozkan and Ozkan (2004) estimate the adjustment factor in a panel of UK firms
to be around (1 0.395) = 0.605 while for Swiss firms, Drobetz and Grninger (2006) estimate it to
be (1 - 0.646) = 0.353. As mentioned earlier, the closer the adjustment factor is to zero, this
implies that firms are adjusting more slowly to their target cash ratio and there are high
adjustment costs. We therefore conclude that the US has the lowest adjustment costs among
those three firms. Contrasting with the regression models of Table 1, we note that the proxy for
growth opportunities, Market to Book Value, loses its statistical significance once we account for
the adjustment factor and endogeneity of firm characteristics in the model. Surprisingly, we also
note that the coefficient of the Credit Rating dummy is positive suggesting that firms with credit
ratings on average tend to hold higher cash holdings. However, the quantum of the effect is small
and this may be due to our sub sample to be populated with more low rated firms (B, BB, BB-)
rather than better rated firms. We also remark the sensitivity of the zscore to instrumenting all
firm characteristics suggesting that zscore may be a redundant independent variable in our
regressions.

3.6 Conclusions
In this paper, we have analysed how firm characteristics influence corporate cash holdings.
Throughout our models, we have identified size, cash flow and leverage as important
determinants of cash holdings. We have identified a non-monotonic relationship between
leverage and the cash ratio arising from financial distress risk of being highly geared. We have
tried to analyse the effect of competition in the banking sector on cash holdings but lack of data
have produced inconclusive results. Future research may focus on a multi-country study with
competition indices at country level or even regional level to study this channel. Our study of lines
of credit have revealed that firms with high financial distress increase cash more if they dont have
such facilities. Building on previous empirical work, we estimated that firms have a target level of
cash ratio but adjustment towards that level is costly. However the adjustment costs are less
expensive on average in the US than in the UK and in Switzerland. We attribute this to the size of
the financial sector in the US compared to the other two countries.

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APPENDIX
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Gompers, A., Ishii, J., and Metrick, A., 2003, Corporate governance and equity prices, Quarterly
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Data Sources:
1. Compustat database.
2. The Federal Deposit Insurance Corporation website for data on the number of institutions
and net loans and leases. Accessible at: http://www2.fdic.gov/hsob/HSOBRpt.asp
3. Data on the lines of credit downloaded from :
http://faculty.chicagobooth.edu/amir.sufi/data-and-appendices/
SUFI_RFS_LINESOFCREDIT20070221DATA.dta

Stata Printout
1. Mean and sample variance
Variable

Obs

Mean

gvkey
fyear
cash
logcash
mvbv

134648
134648
117796
117235
117796

capx
acqu
rd
cf
wc

Std. Dev.

Min

Max

22967.14
1991.422
.1667987
-2.625528
1.684166

36282.42
1000
11.04883
1970
.2218114
0
1.47743 -12.13418
1.568422 .1995213

277918
2011
2.37757
.8660791
137.1828

117796
117796
117796
117796
117796

.0695688
.0168173
.9923556
.0505428
.1516998

.0695221
0
.051998
0
89.74535
0
.1259119 -1.317702
.1885138 -.9205256

1.977968
1.11401
25684.4
.3232583
.922752

lev
lev2
dumdiv
is_cf
zscore

117796
117796
117796
116843
117604

.2184982
.079744
.4388774
.0502003
4.902634

.1788933
0
.1060163
0
.4962521
0
.0241369 .0037806
9.825387 -118.7987

.9718052
.9444054
1
.1162814
1487.741

avgloan
fincrisis
lineofcredit
lnsize
tangi

117796
117796
21388
117796
117733

.5691238
.0789755
.8465962
5.535753
.30163

.026137
.2697017
.3603847
1.843763
.2122553

.6075269
1
1
12.67876
.9887521

.5083468
0
0
1.791849
.0002599

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2. First Regression
. reg cash mvbv rd capx acqu cf is_cf wc lev lev2 dumdiv lnsize zscore fincrisis avgloan tangi, robust
Linear regression

Number of obs
F( 15,116579)
Prob > F
R-squared
Root MSE

cash

Coef.

mvbv
rd
capx
acqu
cf
is_cf
wc
lev
lev2
dumdiv
lnsize
zscore
fincrisis
avgloan
tangi
_cons

.0263052
.0561609
.0630079
-.2872327
.041996
.4460919
-.4010564
-.7464188
.805798
-.0110605
-.0084427
.0020139
-.0281085
-.4221302
-.31236
.6314495

Robust
Std. Err.
.0019632
.0023645
.0091114
.0093459
.0086816
.0343712
.0048001
.0142557
.017978
.0009658
.000285
.0006012
.0021776
.0192326
.0034134
.0105584

t
13.40
23.75
6.92
-30.73
4.84
12.98
-83.55
-52.36
44.82
-11.45
-29.62
3.35
-12.91
-21.95
-91.51
59.81

P>|t|
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.001
0.000
0.000
0.000
0.000

= 116595
= 3554.29
= 0.0000
= 0.5078
= .15582

[95% Conf. Interval]

.0224574
.0515265
.0451498
-.3055505
.0249802
.378725
-.4104645
-.7743597
.7705614
-.0129533
-.0090013
.0008355
-.0323765
-.4598259
-.3190503
.6107552

.0301531
.0607954
.080866
-.2689148
.0590118
.5134589
-.3916482
-.7184778
.8410347
-.0091676
-.0078842
.0031923
-.0238404
-.3844345
-.3056698
.6521437

25

QM7 Applied Econometrics Project

Poushal Gopaul

3. Last regression
. xtabond cash, lags(1) endog(lnsize mvbv cf wc lev zscore dumcr) artests(2) twostep vce(robust)
Arellano-Bond dynamic panel-data estimation
Group variable: gvkey
Time variable: fyear

Number of obs
Number of groups
Obs per group:

Number of instruments =

5.2e+03

=
=

47551
6609

min =
avg =
max =

1
7.194886
25

=
=

985.41
0.0000

Wald chi2(8)
Prob > chi2

Two-step results
(Std. Err. adjusted for clustering on gvkey)
WC-Robust
Std. Err.

cash

Coef.

cash
L1.

.1505915

.0144708

lnsize
mvbv
cf
wc
lev
zscore
dumcr
_cons

.0165287
.0135744
.374942
-.2999009
-.1318541
.0054688
.0207691
.03039

.00517
.0072791
.0359805
.026211
.029575
.0032292
.0076423
.0295275

P>|z|

[95% Conf. Interval]

10.41

0.000

.1222293

.1789538

3.20
1.86
10.42
-11.44
-4.46
1.69
2.72
1.03

0.001
0.062
0.000
0.000
0.000
0.090
0.007
0.303

.0063957
-.0006924
.3044216
-.3512734
-.1898201
-.0008603
.0057905
-.0274828

.0266617
.0278411
.4454625
-.2485283
-.0738882
.011798
.0357477
.0882627

Instruments for differenced equation

GMM-type: L(2/.).cash L(2/.).lnsize L(2/.).mvbv L(2/.).cf L(2/.).wc L(2/.).lev L(2/.).zscore L(2/.).dumcr
Instruments for level equation
Standard: _cons

26