Bridge over ocean
1 September 2016 CFA Institute Journal Review

Cash Holding Adjustments and Managerial Entrenchment (Digest Summary)

  1. Marc L. Ross, CFA

Managerial attitudes toward corporate governance are often reflected in the speed and manner in which firms manage their cash ratio.

What’s Inside?

Firms, on average, close 31% of the gap between the target cash ratio and actual cash ratio annually. How quickly they do often indicates the firm’s financial condition and economic outlook for its industry and reflects how entrenched or self-interested senior management is running the company.

How Is This Research Useful to Practitioners?

The authors submit that the rate at which firms close the gap between actual and target cash ratios reflects the cost of deviating from an “optimal cash ratio” of funds on hand to run their particular business as well as management’s willingness to assume risks that may come with changes to the ratio. Ratios that are too low may indicate imprudent spending and potential financial distress. Those that are too high could put the firm at the risk of underinvesting by being too circumspect. The costs of having deficient versus excessive cash piles on the balance sheet differ. In the authors’ opinion, operating with insufficient cash is more expensive than doing so with excess cash. Accordingly, adjustments tend to be swifter, particularly if financial and operating risks are greater.

To test their hypotheses, the authors examine a large dataset covering the period from 1980 to 2006. They observe that the average firm over this time period closes 31% of the difference between the target and actual cash balances on hand. The authors further note that for all of the firms in the sample, the adjustment speed is faster (33%) when the cash level is higher than the target ratio than when it is at the target (29%), implying that getting rid of cash is less costly than accumulating it. The authors also look at how adjustment speeds can vary for financial and operating risks. Companies with low leverage and rated debt can raise cash more easily and, hence, are less concerned about a low cash balance. When the opposite holds, raising cash quickly would become a priority. For operational risk, the more volatile a firm’s cash flow is, the greater is the need to raise cash quickly.

Finally, the authors consider how cash ratio adjustment speeds reflect the influence of business combination laws passed in many US states from 1985 to 1991 as well as changes in the takeover environment in Delaware in the mid-1990s on senior management’s tendency toward self-interest (entrenchment). Firms with a cash level beyond their target ratio reduced adjustment speeds in those states that passed business combination laws. A similar result occurred for firms in Delaware, which reduced adjustment speeds after 1995 compared with non-Delaware firms, again with cash balances above their target ratio. For students of corporate finance and financial statement analysis (particularly on the sell side), the authors’ research will increase their understanding of how the speed of a firm’s cash management policy reflects its financial condition and corporate governance.

How Did the Authors Conduct This Research?

Critical strands of literature on firms’ cash management activities include the topics of cash levels and adjustments, capital structure adjustments, and business combination laws. These studies inform the authors’ research.

Their dataset consists of firm-year observations taken from Compustat over the period of 1980–2006, just prior to the financial crisis when the drivers for holding cash were quite different from those in the pre-crisis period. Sample firms had to have positive assets and sales. The analysis excludes utilities and financial firms whose cash assets can be subject to regulatory oversight.

The authors test their hypotheses using regression analysis along with robustness tests to control for the occurrence of heteroskedasticity and autocorrelation when estimating the target level of a firm’s cash holdings. The analysis begins with a two-stage regression of cash ratios against such independent variables as firm size and age, industry cash flow risk, cash flow, capital expenditures, leverage, and acquisition activity. Younger, smaller firms with large growth opportunities and facing greater risk have more cash.

The authors use several approaches to estimate adjustment speeds for capital structure. Firms close a substantial gap between actual and target cash ratios each year. Adjustment speeds accelerate the greater the spread between actual and target cash levels. The authors then estimate the effect of operating and financial risk on cash adjustment speeds using cash flow volatility and leverage and running regressions for firm years with cash higher than versus less than the target. Firms raise cash levels that are less than the target in the face of financial risk or the lack of a debt rating.

The authors consider the influence of entrenchment shocks from the outside on adjustment speeds by evaluating how managerial self-interest could increase with greater entrenchment. To control for the difficulty of evaluating the relationship between managerial holdings and cash adjustment speeds (because increases in the former reflect the extent of both manager and shareholder alignment and entrenchment), the authors consider the effects of external shocks to the takeover landscape in 30 states that adopted business combination laws from 1985 to 1991 as well as Delaware in the mid-1990s and their effect on cash adjustment speeds. The authors run regressions that incorporate these types of shocks. Entrenched firms slow down cash adjustments at high, but not low, levels of cash.

Abstractor’s Viewpoint

Not only how firms manage cash, but the speed at which they do, reflects their style of corporate governance. The speed of changes in cash levels at a company tells many stories: Desire for industry dominance through acquisition could motivate a corporate spending spree, whereas a need to be cautious based on a more downbeat outlook could motivate a buildup of reserves to withstand decreased revenues or put up a takeover defense. Furthermore, the speed or lack thereof of any such adjustments could reflect a certain level of urgency, complacency, or a changed regulatory environment when considering the best use of cash. How firms manage their cash adjustment speeds since the onset of the Great Recession as well as how senior management in other outposts of the corporate world view this function could be worthwhile topics for future study.

We’re using cookies, but you can turn them off in Privacy Settings.  Otherwise, you are agreeing to our use of cookies.  Accepting cookies does not mean that we are collecting personal data. Learn more in our Privacy Policy.