Aurora Borealis
1 August 2017 CFA Institute Journal Review

The Joint Determinants of Cash Holdings and Debt Maturity: The Case for Financial Constraints (Digest Summary)

  1. Victor E. Jarosiewicz, CFA
Firms tend to hold more cash when they hold longer-term debt, and vice versa. This result is true even when controlling for overall leverage and when considering the joint determination of all three variables. The authors’ results are found mainly in the subsample of financially constrained firms, which have a precautionary motivation owing to less access to credit.

How Is This Research Useful to Practitioners?

The authors address a simple question—Do firms with more long-term debt tend to have more or less cash?—and make two main findings. They confirm, empirically, that cash and debt maturity have a mutually positive effect on each other, and they show that this finding is particularly (and often only) true for financially constrained firms (i.e., firms with debt not rated, with no dividend payments, or of a relatively small size). Both the surprise and the value of the authors’ findings are in the contrast between financially constrained and nonconstrained firms. For practitioners, the positive perspective (of the precautionary motivation for financially constrained firms to hold more cash when they hold more long-term debt) may be useful when benchmarking or analyzing different types of firms’ use of cash and debt structure.

Financially constrained firms appear to have a precautionary motivation for holding cash, as reflected by a positive relationship between the level of cash and the maturity of debt—in contrast to firms that are not financially constrained. This finding is also true for firms with more growth opportunities subject to future funding needs (proxied by market-to-book and R&D spending ratios).

The authors cite prior researchers’ findings on the links between cash and leverage and between leverage and debt maturity. None of the previous researchers combines all three elements or controls for the endogenous nature of simultaneously choosing all three variables (cash, total leverage, and debt maturity).

For creditors and financial analysts, the authors help in understanding the differences between financially constrained and nonconstrained firms. Prior researchers have suggested that holding cash and longer debt is indicative of managerial entrenchment and of underinvestment from debt overhang—both negative motivations. The authors present a different (and positive) motivation to consider for financially constrained firms.

How Did the Authors Conduct This Research?

Examining a large panel of firms over 1985–2013, the authors focus on 11,729 publicly traded firms outside financial services and regulated industries. Starting with typical ordinary least squares (OLS) analyses, they duplicate prior unidirectional effects of debt maturity on cash and of cash on debt maturity.

The authors’ main methodological advantage is in their GMM (generalized method of moments) analysis, which allows the modeling of the (endogenous) simultaneously determined variables of cash, leverage, and debt maturity. Debt maturity affects cash levels, but cash also affects debt maturity; both affect, and are affected by, leverage. The authors use the methodology of Arellano and Bover (Journal of Economics 1995) to identify valid instrumental (lagged) variables, allowing the system of equations to be estimated. Using a number of alternative measures of financial constraints, they split the sample and find support for their overall conclusion that the positive relationship between cash and debt maturity is strongest for (and often exclusive to) financially constrained firms.

Splitting the sample along a number of other dimensions and re-estimating the system of equations allow the authors to exclude several other plausible explanations. The results are probably not driven by a lack of monitoring (agency problem), international tax considerations for repatriating cash held overseas, greater default probability (as distinct from financial constraint), or CEO overconfidence. The 2007–08 financial crisis is also not a driver; the results do not differ between the pre- and post-crisis samples.

Abstractor’s Viewpoint

By extending prior analyses dealing with only cash and leverage or only leverage and debt maturity, the authors expand our understanding of these codetermined financial decisions. As with much financial research, however, the analysis is, by its very nature, cross-sectional. Although it does help uncover the differences between financially constrained and nonconstrained firms, I would like to see future research consider the evolution of firms from financially constrained to not and vice versa—and how that change over time either drives or is affected by the codetermined levels of cash and debt maturity. Research into what evolutionary paths are more or less likely to change firms from constrained to nonconstrained, and how those changes affect cash and maturity, would be even more helpful to practitioners.

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