The authors contribute to the discussion on whether the cash flow sensitivity of cash (CCFS) reflects a firm’s financing constraints. They find that the CCFS is not an adequate way to capture financing constraints. Rather, a higher CCFS indicates smoothing of variability in income by creating a cash buffer against future income shocks.

Previous empirical studies showed that firms generally tend to hold too much cash. Firms hold cash, according to traditional explanations, to avoid the lack of liquidity that could hinder growth prospects and/or lead to default. Over the years, there have been additional explanations for holding cash. For example, another motive to hold cash that has been suggested is the agency costs of free cash flow; firms with entrenched managers will hold cash rather than distribute it to shareholders in case of poor investments.

Cash is an important element from the perspective of both the balance sheet and cash flow statement when valuing a company. Investment practitioners need to understand why most firms tend to hoard cash and why only a few do not. The authors build on an existing body of research on this topic. Various studies have shown that a firm’s propensity to save is based on a financing constraint (i.e., firms save more because of the lack of alternative means of financing). But the authors refute that line of thinking.

They find that firms with a higher CCFS do not depend more on external financing. Their sources of financing are not constrained, and they do not have to pay higher financing costs. Rather, a firm’s decision to save is motivated by its income variability. Firms with a high CCFS generally have high income uncertainty, and their decision to save is designed to create a cash buffer against future income shocks.

The authors add to the existing body of literature that focuses on why firms tend to hold cash and whether that decision is influenced by financing constraints. But this study differs from previous studies in that the authors are able to estimate the CCFS for each individual firm, whereas previous studies have only been able to estimate a single CCFS for the subsample investigated. So, they are able not only to avoid the endogeneity problems that might bias sample-level CCFS but also to assess in detail firm characteristics that are associated with a high or low CCFS.

The authors use a dataset of 151 Belgian listed firms over the sample period 2002–2010 (1,359 firm year observations). The choice of Belgium is motivated by the fact that the Belgian economy is driven by smaller firms for which financing constraints are more pronounced, is bank based, and has a relatively undeveloped stock market. In addition, Belgium has relatively little investor protection.

From an investment practitioner’s perspective, cash, or the lack of cash, is an important aspect of any firm’s balance sheet and cash flow statement. The authors’ finding that a firm’s decision to hold cash is dependent on the firm’s income variability and not influenced by financing constraints has different implications. For example, when analyzing a firm with a large cash position, investors do not need to attribute that position to a lack of investment opportunity but to the firm’s decision to create a cash buffer for future income shocks. This approach might not be right for large firms, but it makes sense for smaller firms with lumpy earnings.