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Does the financial crisis impact cash holdings?
Evidence from Europe
Huan Chen
S2512777
Supervisor: dr. H. Gonenc
Jan 2015
Faculty of Economics and Business University of Groningen
Abstract
The level of cash holding can reflect some operating and financing situations, but meanwhile, it is influenced by some micro- and macroeconomic situations. There are plenty of studies on this topic, including the determinants of cash ratio and whether the negative economic shock would influence the cash ratio. Based on the previous study, I will focus on the research in Europe and examine whether the financial crisis would impact cash holding levels for European companies.
In order to investigate the impact, I come up with two hypotheses based on the previous research and the effect of the financial crisis in Europe. Firstly, the cash ratio during the financial crisis is significantly different from before. Secondly, the firm characteristics cannot explain the cash ratio during the financial crisis.
By using the data from 2000 to 2012 in European companies, I find out that the cash ratio during the financial crisis is significantly different from the ratio before the crisis. The fluctuation in cash ratio as U-shape is consistent with research in Kahle and Stulz (2009). Apart from that, I also find that the firm characteristics cannot explain the cash ratio during the financial crisis, and this result is consistent with and Song and Lee(2012).
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Introduction
From recent research by Deloitte, we can see that the leading 1,000 public non-financial firms around the world reserve $3.53 trillion in cash by the end of 2013. US, as the largest economic institute of the S&P Global 1200, hold $1.6 trillion in cash. 1 Apart from these static figures in 2003, Bates et al. (2009) document a secular increase in the cash holdings of U.S. firms from 1980 to 2006. Specifically, the average cash-to-assets ratio for U.S. industrial firms is more than twice. Corporates accumulate cash for some reasons, some market commentators would take the cash ratio as a crucial indicator to boost capital expenditure(capex) and M&A activities2, some scholars would state that the research on cash holding would facilitate the research on corporate valuation. For example, Kin-Wai Lee, Cheng-Few Lee (2009) find that there is a negative relationship between cash level and firm value. In addition, the level of cash would decide the capability of investment in research and development (R&D)to achieve more growth. Due to the importance of corporate cash holdings and its increasing significance on both micro and macro level of the economy, this paper would shed light on the cash holding in a special situation and see how the negative economic shock would influence the corporate cash holdings in a complicated and multinational economic region, Europe.
In order to investigate the impact of the financial crisis on corporate cash holdings, various studies in the history focus on the determinants of cash holdings. For example, Bates et al. (2009) discover that the change of U.S. firms’ cash holdings during the period from 1980 to 2006 is closely related to the risk and net working capital (NWC), and the investments on R&D. Underlying these determinants, some theories have been raised by several scholars, for example, the trade-off theory, the pecking order theory, and the free cash flow theory. In order to investigate the impact of financial crisis on cash holdings, these theories need to be discussed and examined. Thus, a short introduction of these three theories are discussed in the following.
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The cash paradox: How record cash reserve are influencing corporate behavior? Deloitte Review Issue 15
http://dupress.com/articles/excess-cash-growth strategies/?id=gx:2sm:3gp:4dup779:5eng:6dup:20141021152700:dr15
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The cash paradox: How record cash reserve are influencing corporate behavior? Deloitte Review Issue 15
Firstly, Kim et al. (1998) develop a trade-off model of optimal cash holdings. It suggests that firms trade off the benefits and costs of holding cash so as to reach the optimal cash level. As for the specific benefits and costs, the trade-off theory considers not only the transaction costs, but also the precautionary effect. Besides, there are plenty of empirical supports of the trade-off theory. Opler, et al. (1999) examine the determinants of cash holdings with publicly traded U.S. firms in the period 1971-1994, and find ample evidence to support this theory.
Secondly, the pecking order theory supported by Myers and Majluf (1984), argues that firms prefer to finance investments first with retained earnings, then with safe debt and risky debt, and lastly with equity considering the financing cost and asymmetric information costs. In other words, the pecking order theory suggests that firms have a preference to use internal finance over external finance for investments. Similar to the pecking order theory in financing, the pecking theory of cash holding shows that there is also no target or optimal cash holding level and cash is just used to buffer the retain earning and investment needs.
Finally, as Jensen (1986) states, there are several motives for managers to hoard cash as assets in hand. For instance, it could provide more discretion for managers to make the firm's investment decision. This theory is called the free cash flow theory, it suggests that managements would experience less pressure to improve performance and more freedom to invest in the projects in which they are interested, rather than those only to maximize the shareholders’ wealth. However, the governance of cash holdings also plays a vital role in the cash holding levels, for example, La Porta et al. (2000) prove that corporates in U.S. hold more cash due to the dividend payments policy, and the U.S. is more strict in protecting shareholders’ rights.
5 countries could not be applied to European firms due to difference in governance of cash holdings and costs of funding or investment. They also state that the trend in cash holdings of East Asian firms over the sample period is very different from that of the firms in developed countries over the same period. Besides, the U.S. research could not be applied to European firms due to the American taxation system and the difference in shareholder protections. Therefore, there is necessity to investigate the impact of the financial crisis on cash holdings in European countries.
In this paper, I use a sample of firm-years representing 6,741 European firms over the period 2000–2012, I first examine the trend in cash holdings before and during the financial crisis in those European countries. The sample firms come from 17 Western European countries, namely, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom. I find that there is a significant change in cash ratio during the whole sample period, especially the first year of the financial crisis:2008. The mean cash ratio goes down first from 16.0% in 2007 to 14.7% in 2008, even though the figure climbs up again later from 14.7% to 15.2% in 2010, the whole trend from 2000 to 2012 is still in decrease. The median data share a similar change with the mean data. Moreover, during the fluctuation of mean(median)cash ratio, we can see a U-shape change in the analysis graph 1 and graph 2, respectively.
I research the change of cash ratio between pre-financial crisis and during financial crisis, and examine whether the change in cash ratio is result from the change in firm characteristics, assuming that the firms’ demand function of cash has not changed. In terms of the previous research, Bates et al. (2009) find that the increase of U.S. firms’ cash holdings in the 1990s and 2000s is related to the increased risk, the lower NWC, and more R&D investments. More importantly, Song and Lee (2012) find that the firm characteristics, like cash flow, growth opportunities, and cash flow volatility, have changed significantly in the course of the crisis. They also state that these changes do not explain the Asian firms’ higher cash holdings in the post-crisis period. By using the West European companies sample during the financial crisis, I also find out the changes of firm characteristics is not enough to explain the changes of cash holdings.
impact of the financial crisis on cash holdings. After the literature review, the hypotheses will be raised. Secondly, the methodology including data collection and variables is shown. Thirdly, and most importantly is the discussion on the empirical result from the previous section, after which I examine whether it accepts the hypotheses or not. Then, I also list whether these results are consistent with some existing studies, which have been conducted in other countries or other time periods. I end with conclusion and limitations.
Literature Review
It is argued that the financial crisis has an influence on the corporate cash holding level, because transaction costs would change along with the macroeconomic situation. This suggest that the transaction cost including the cost of converting the cash substitutes into cash in the future for investment purposes will rise. Moreover, the precautionary motive also drives companies to hold more cash in hand. To avoid difficulty of getting access to the capital market to raise for new investment projects during the financial crisis, comanies will normally choose to hold more cash. On top of that, the corporate cash holding policy would also influence the cash holding level in negative economic shock. As a whole, therefore, it is expected that the cash holding level during financial crisis is different from the normal macroeconomic situation.
7 more cash in the case that this ratio is taken as a proxy for the financial distress costs. In light of the amount of cash holdings, it also varies from firm to firm. For instance, Dittmar and Mahrt-Smith (2007) show that well governed firms experience a smaller increase in cash holdings than the weakly governed firms. Unlike the research in Song and Lee (2012), by using the data from 2006 to 2010, Kahle and Stulz (2013) discover that the financial crisis has not impacted the cash holding levels significantly over the whole period. They see a significant decrease in the first year of the crisis and the post-Lehman period, but an increase during these two periods and afterwards. Basically, they show a U-shape fluctuation during the crisis. Based on these studies, it can be seen that the cash ratio changes before and during financial crisis are ambiguous.
In order to find out how the financial crisis influences the cash ratio in companies, this study will introduce some previous researches to clarify the determinants of cash holdings. For example, Opler, et al. (1999) identify some variables, including firm size, leverage, market-to-book ratio, cash-flow-to-total-assets ratio, standard deviation of cash flow for the past ten years, NWC-to-total-assets ratio, R&D-to-sales ratio, capital-expenditures-to-assets ratio, acquisition-spending-to-assets ratio, a dividend dummy (which assumes a value of one if a company pays a dividend and zero otherwise), and a bond dummy (which assumes a value of one if the firm has S&P long-term ratings and zero otherwise). Furthermore, Ferreira and Vilela (2004) estimate a model of cash holdings using data from the 1980s and use it to predict the determinants of cash holdings in the 1990s and the 2000s. They use the model to assess how changes in firm characteristics explain the increase in cash holdings. Four variables are particularly important to explain the increase. First, working capital, particularly fewer inventories and accounts receivable, is declining. Considering net working capital is the substitute of cash, then cash would increase. Second, cash flow volatility which represents the risk increases substantially. Since cash holdings are positively correlated to risk, the increase in risk has a substantial positive impact on cash holdings. Third, capital expenditures decline, and cash is negatively correlated with capital expenditures. Fourth, R&D expenditures increase, and firms with higher R&D expenditures hold more cash. Similar to Ferreira and Vilela (2004), Bates et al. (2009) find that the increase of U.S. firms’ cash holdings in the 1990s and 2000s is related to increased risk, NWC, and R&D investments.
merger and acquisition (M&A) activities and on capital expenditures, and this leads to the increase in cash holdings. As an explanation, they show a distinct negative relation between investments and cash ratios, particularly after the financial crisis. Moreover, Pinkowitz, et al. (2013) even classify the positive and negative relationship among these variables, in which industry cash flow volatility, market-to-book ratio, R&D expenditures, debt issuance and equity issuance are identified as positive relevant, while size, cash flow, NWC, capital expenditures, leverage and acquisitions are all negatively related to cash holding.
In order to further discuss how those factors impact the corporate cash holdings during the financial crisis, three theories developed from the previous literature will be introduced. Basically, they are the trade-off theory, the pecking order theory and the free cash flow theory. Within these theories, two motives are involved, namely the transaction motive and the precautionary motive. More details for the three theories as follows.
A. The Trade-off Theory
As mentioned, Kim, et al. (1998) develop a trade-off model of optimal cash holdings by using a large panel of U.S. industrial firms over the period from 1975 to 1994. In this model, corporates strives to find a trade-off between the holding cost of liquid assets (a low return) and the benefit of minimising the need to fund profitable future investment opportunities with costly external financing, in order to optimise corporate investment in liquid assets. Dittmar, et al. (2003) specify the benefits and costs in the trade-off theory. Firstly, the cost is different with different assumptions. Under the assumption of shareholder wealth maximisation, namely, there is no agency problem between shareholders and managements. In this case, the cost in this theory is the difference between the return on cash and the interest that would have to be paid to finance an additional cash (in other words “cost-of-carry”). On the other hand, if the managements do not take the shareholder wealth maximisation as priority, then the costs of holding cash increase, since managers now have the opportunity to engage in wasteful capital spending and acquisitions under the assumption of agency conflict.
9 1952; Miller and Orr 1966). Likewise, firms which have more investment opportunities or have more difficulty to get access to capital market would hold more cash for the operational reason. Besides, the precautionary motive would also be considered into the trade-off theory, because the precautionary motive is generally accepted as the primary driver of cash policy. When access to capital markets becomes costly, it is necessary to hedge against the risk of future cash shortfalls or to deal with future adverse shocks otherwise. By definition, the precautionary motive is the buildup of cash for precisely this reason. Particularly when the securities are undervalued, a firm may choose not to increase financing, even though they have access to capital markets. As a solution, Myers and Majluf (1984) argue that financial slack can be built up. Financial slack is defined as cash, cash equivalents, and unused risk-free borrowing capacity.
In order to further investigate these two motives to help analyse the cash holding factors, more details and previous researched are discussed in the following.
1. The transaction motive
Keynes (1936) states that there are some costs to convert the cash substitutes into cash, it is better for a corporate to hold some cash in order to avoid the transaction costs of selling illiquid assets and using capital markets to raise funds. Besides, due to the fixed fees of transaction, it is more likely that small firms would hold more cash than larger firms, which is called economies of scale in cash (Miller and Orr (1966)). Later, Mulligan (1997) proved the existence of economies of scale in cash.
2. The precautionary motive
Because the capital becomes more expensive or even more difficult to get access to, during or after a negative economic shock, Opler, et al. (1999) argue that firms with riskier cash flows and poor access to external capital hold more cash in which they ues market-to-book ratios and R&D spending as proxies for investment opportunities.
B. Pecking order theory
This theory suggests that firms do not have target cash levels, but instead, cash is used as a buffer between retained earnings and investment needs. There is no optimal level of debt cash balances are simply the outcome of the investment and financing decisions made by the firm as suggested by the pecking order theory of financing. Thus, when current operational cash flows are enough to finance new investments, firms repay debt and accumulate cash. When retained earnings are not enough to finance current investments, firms use the accumulated cash holdings and, if needed, issue debt.
C. Free cash flow theory
Previous literature also finds that the agency problem is an important determinant of cash holdings. Jensen (1986) suggests that managers have an incentive to hoard cash to increase the amount of assets under their control and to gain discretionary power over the firm investment decision. Ozkan and Ozkan (2004) discover a negative relation between the cash holding and the managerial ownership in U.K. firms. With enough cash in investment, it is not necessary for managers to provide detailed information so as to raise external funds for the firm's investment purposes. In this case, it is possible for managers to spend cash on their own good instead of shareholders. It is also argued that larger free cash flows go along with the more severe agency conflict between shareholders and managers. On top of that, the research across different countries is consistent with agency costs of free cash flows. Speaking of the agency problem, it suggests that the information is asymmetrical between inside and outside investors, or between managers and shareholders. Jensen (1986) points out that the entrenched managers would rather retain the cash than pay to shareholders even when there is no good investment opportunity for the firms at that moment. Moreover, Dittmar et al. (2003) extend the research across countries and find that firms hold more cash in countries which have greater agency problems. Pinkowitz, et al. (2006) share a similar result internationally. Basically, the agency view of cash holdings suggests that, everything else being equal, firms with poorer governance experience greater increases in abnormal cash holdings because they are less likely to pay the dividend to shareholders.
11 increase. Besides, the financial crisis makes the financial and economic situation more difficult to predict. In order to keep the investment opportunity in the future with enough cash, or avoid the risk of bankruptcy, firms would choose to hoard more cash, this is called precautionary motive. Secondly, according to the pecking order theory, firms do not have target cash levels, but instead, cash is used as a buffer between retained earnings and investment needs. Thus, when current operational cash flows are enough to finance new investments, firms repay debt and accumulate cash. Otherwise, firms use the accumulated cash holdings (and, if necessary, issue debt), in order to finance current investments. Obviously, during the financial crisis, there are limited investment opportunities for companies, then the cash holding level should be significantly different from before the financial crisis, when everything else is equal. Thirdly, the free cash flow theory suggest that managements have motive to hoard more cash so as to realize their own interests in career rather than maximize shareholders’ wealth. Basically, the agency's view of cash holdings suggests that, firms with poorer governance, assuming other parameters to be unchanged, experience greater increases in abnormal cash holdings because they are less likely to pay the dividend to shareholders. It can be seen from the case of the Sarbanes-Oxley act, which shows that firms influenced by Sarbanes-Oxley would have higher cash holdings, everything else taken to be equal (Pinkowitz, et al.2013). Moreover, Kirkpatrick (2009) conclude that the financial crisis can be, to an important extent, attributed to failures and weaknesses in corporate governance arrangements. Therefore, the cash holding level during financial crisis would be statistically different from before the financial crisis, according to the free cash flow theory.
To analyse the impact of the financial crisis on European corporate cash holdings, more details concerning the Eurozone and the financial crisis history will be shown in the following. In the Eurozone as a whole, the Maastricht treaty has been invoked to limit deficit spending and debt levels of all EU members. This decision was taken in 1992, as a guidance for a healthy and stable financial climate continent-wide. Until the early 2000s, though, not all members have adhered to this agreement. By 2008, some banks came under undercapitalisation issues, and at the same time others underwent liquidity and debt problems. Meanwhile, the economy slowed down in Eurozone countries, which indicates the onset of the financial crisis in Europe.3
As for the effect from this financial crisis, it made it difficult and expensive for many non-financial firms to obtain external financing. As an alternative to external funding such as bank loans, bond offerings, and equity offerings, such firms choose to increase cash holdings. There are plenty evidence to support this. In practice, according to the Liquidity Management Poll conducted by the American Productivity and Quality Center in March 2009, 9 out of 10 finance executives report that their companies have taken increasing cash holding level as the top corporate priority. In theory, some recent studies have investigated how the global financial crisis has changed the short-term management policies of firms. For instance, according to Duchin et al. (2010), firms in the U.S. tend to spend up much of their cash holdings in times of global crisis. In agreement with them, Arslan et al. (2006) find investments in crisis times to be tightly bound to internal funds. Campello et al. (2010) see a lot of sample companies postpone or cancel investment projects during the period of tight capital markets. Therefore, both the theoretical and practical evidence indicate that the precautionary motive for holding cash is prevalent in times of a crisis. In other words, following negative macroeconomic shocks, firms adjust their policies to increase their prospensity in an effort to save cash and spend conservatively.
This paper specifically focuses on the differences around the financial crisis and the expectation is that during the financial crisis firms hold different level of cash holdings based on the previous research, which is the first hypothesis:
H1: The cash ratio during financial crisis is significantly different from the cash ratio before financial crisis.
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H2: The change in firm characteristics cannot explain the changes in corporate cash ratio in the financial crisis.
Data and Methodology
1. Sample
I construct our sample of firms from the Worldscope database for the period from 2000 to 2012. The financial crisis initially emerged in the U.S. because of the housing bubble. Later, it spread into Europe in 2008, and continue until now (Cameron, 2010). The reason why I choose this time period is that it allows me to analyse the effects of the financial crisis in the years from 2008 to 2012 (Great Recession4). The selection of European firms is based on their ISO country codes. I restrict my sample to firms that are incorporated in the 17 countries affected by the financial crisis around 2008: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom. Additionally, I only apply firms with positive assets and positive sales for a given year in the sample.5 Following most empirical studies on cash holdings, I exclude financial firms with Standard Industrial Classification (SIC) codes of 6000–6999 because they may carry cash to meet the regulations of the industry or individual country. Also utilities (SIC-codes 4900-4999) are excluded, since their cash holdings might be under regulation. Therefore, my final sample consists of 55,950 observations of 6,741 unique firms. In the process of the data management, I found some outliers. In order to deal with the outliers to run the regression, outliers of all ratios are winsorised at 1% level on both sides. Table A1 shows the number of observations and unique firms per country. For the analysis I utilise a panel dataset which has both a cross-sectional and a time series dimension, which allows for an analysis of different firms over time. Every firm-year observation contains information on the cash/assets ratio and all independent variables which are described earlier. Due to limitation to data access and the difficulty of research, I only apply some important determinants, namely, capital expenditure ratio, acquisition ratio, EBIT ratio, firm size, leverage, market-to-book ratio and net working capital ratio.
4 European debt crisis: http://en.wikipedia.org/wiki/European_debt_crisis
2. Variables
Dependent variable:
The dependent variable used in the regression analysis is the cash ratio, which is defined in different ways, following the most straightforward way is to divide cash by the total assets of the firm.
Independent variables:
All the relevant variables to impact the corporate cash holding are shown below, some of these variables in different theory influence the cash holdings in a different way, even in a different direction.
Firm size
15 the pecking order theory, the free cash flow theory suggests that larger firms tend to have a larger shareholder dispersion, which gives rise to superior managerial discretion. Moreover, as Harford et al. (2008) take firm size as a proxy for the takeover deterrent, it indicates that larger companies are not likely to be the target of a takeover due to the amount of financial resources needed by the bidder. Thus, it is expected that managers of large firms have more discretionary power over the firm investment and financial policies, leading to a greater amount of cash holdings. Then, these arguments suggest a positive relation between size and cash holdings. As a whole, different theories offer different relationships between firm size and cash ratio, which suggests an ambiguous relationship.
Table 1A
Trade-off theory Pecking order theory Free cash flow theroy
Firm size Negative Positive Positive
Market-to-book ratio
I measure market-to-book ratio as the sum of total debt and the market value of equity, divided by the book value of total assets. On one hand, trade-off theory points out that the market-to-book ratio is an important indicator in the cost of transactions motive, because it captures growth opportunities. Better investment opportunities are expected to hold more cash because the opportunity cost of lost investment is larger for these companies. Besides, Keynes (1936) states that riskier firms and firms with more growth opportunities should hold more cash. Therefore, the market–to-book ratio should be positively related to the cash holding level. On the other hand, from the perspective of free cash flow, the managements prefer to hoard more cash, to ensure the availability of funding growth projects, even though the NPV of this project is negative. Thus, there is a negative relationship between investment opportunity and cash ratio. The specific relationship in different theories can be seen in table 1B.
Table 1B
Trade-off theory Pecking order theory Free cash flow theroy
Market-to-book ratio Positive Positive Negative
Capital Expenditure Ratio
with cash holding level as the pecking order theory. In other words, Dittmar et al. (2003) conclude that the major difference between the two views is that the tradeoff theory predicts a positive relationship between investment (in capital expenditures and R&D) and cash levels, while the pecking order view predicts a negative sign. As a whole, thus, the ratio of capital expenditures to book assets has an ambiguous relation with cash holdings. The specific relationship in different theories can be seen in table 1C.
Table 1C
Trade-off theory Pecking order theory Free cash flow theroy
Capital Expenditure Ratio Positive Negative
Acquisitions to assets Ratio
The acquisition to assets ratio is defined as acquisitions divided by book assets. The relation with cash ratio is same as with capital expenditure.
Net working capital ratio
I measure the net working capital ratio as the working capital minus cash, divided by book value of assets. Net working capital can be seen as a substitute for liquid assets. Consequently, firms with more liquid asset substitutes are expected to hold less cash (Ferreira, Vilela, 2004). Thus, there is a negative relationship with cash holdings. The specific relationship in different theories can be seen in table 1D.
Table 1D
Trade-off theory Pecking order theory Free cash flow theroy
Net working capital ratio Negative
Leverage
17 As a result, the cash ratio is negatively correlated to the leverage. Consistent with the pecking theory, the free cash flow theory states that low leverage firms are under less pressure to be monitored, which gives management more discretion. Thus, it is expected that less levered firms hold more cash. In total, the relationship between leverage and cash ratio is ambiguous. The specific relationship in different theories can be seen in table 1E.
Table 1E
Trade-off theory Pecking order theory Free cash flow theroy
Leverage Unknown Negative Negative
EBIT Ratio
I measure cash flow as the EBIT (earnings before interest and taxes) divided by the book assets. As for the relationship, the trade-off theory has a different opinion from the pecking theory. On one hand, Kim et al. (1998) think that cash flow provides a ready source of liquidity, and it can be seen as a cash substitute. Thus, Ferreira and Vilela (2004) state a negative relation between cash flow and cash ratio. However, pecking order theory indicates that firm with high cash flow have more cash ratio, assuming everything else to be equal. The specific relationship in different theories can be seen in table 1F.
Table 1F
Trade-off theory Pecking order theory Free cash flow theroy
EBIT ratio Negative Positive
As a whole, the table 1G provides the overview of the relation between cash ratio and all other variables, based on the three theories.
Table 1G
Trade-off theory Pecking order theory Free cash flow theroy
Firm size - + +
Market-to-book ratio + + -
Capital Expenditure Ratio + -
Net working capital ratio -
Leverage Unknown - -
EBIT ratio - +
3. Descriptive Statistic
TABLE 2
Descriptive Statistics
The panel data on 55,950 firm-years representing 6,741 sample firms in 17 European countries are collected from Worldscope. Table 2 reports the number of firm-years (N), the mean, median, maximum, minimum, and standard deviation (STD) for each variable. Here, N is the number of non-missing observations of each variable. Cash ratio is the ratio of cash to the book value of total assets. EBIT ratio is used to measure the cash flow, and masured by EBIT/assets. Firm size is measured as a natural logarithm of the book value of total assets. The acquisition ratio is measured as the acquisition cost divided by the book value of total assets. The capex ratio is measured as the capital expenditures to book value of assets. Leverage is the ratio of total debt to the book value of total assets. The market-to-book ratio is calculated as the sum of total debt and the market value of equity, divided by the book value of total assets. The NWC ratio is the ratio of net working capital minus cash to the book value of total assets.
Variables Obs Mean Median Maximum Minimum Std. Dev.
CASH_RATIO 55,919 0.1543 0.0894 0.8455 0.0000 0.1768 CAPEX_RATIO 55,919 0.0470 0.0298 0.3255 0.0000 0.0564 ACQUISITION_RATIO 55,919 0.0143 0.0000 0.2948 0.0000 0.0455 EBIT_RATIO 55,919 -0.0070 0.0518 0.3833 -1.5196 0.2587 FIRM_SIZE 55,919 5.1725 5.1073 7.7520 2.9385 1.0161 LEVERAGE 55,919 0.2213 0.1881 0.9539 0.0000 0.2008 M2B_RATIO 55,919 1.0389 0.6087 9.3464 0.0000 1.4127 NWC_RATIO 55,330 0.0091 0.0136 0.5207 -0.7892 0.2079
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Empirical Findings
This section focuses on the examination of the two hypotheses mentioned in the literature review. In the first place, the cash ratio during the financial crisis around 2008 in European companies is expected to be significantly different from the cash ratio before the financial crisis. In order to do research on the difference, I will firstly run the time series change across the companies for the cash ratio and also some important factors influencing the cash ratio, then compare the difference. Some graphs will be introduced to show the trend of change. On top of that, I compare the mean and median cash ratios in these two periods (2000–2007 vs. 2008–2012) with the t-test. In the second place, the firm characteristics could explain corporate cash holdings, but during financial crisis they change dramatically, thus, the firm characteristics may be not enough to explain the cash ratios during the financial crisis, which is hypothesis 2. In order to examine whether the firm characteristics are different in the pre-crisis period versus during the pre-crisis (2000–2007 vs. 2008–2012), I compare the mean and median of the firm characteristics of these periods. Then, I compare the different regressions among Fama-MacBeth’s, Fixed effects of firms, Random effects of firms, and also OLS regressions, to find out the most proper regression. Based on the most proper regression, I compute how actual cash ratios differ from those predicted by that regression in the period of crisis.
Part A
H1: The cash ratio during financial crisis is significantly different from the cash ratio before financial crisis.
TABLE 3
Cash ratio, capital expenditure ratio and leverage by year
Table 3 reports the number of firm-years and the mean and median ratios of cash, leverage, firm size and capital expenditure, year by year. Cash ratio is the ratio of cash to the book value of total assets Capital expenditure ratio is measured as capital expenditures divided by the book value of total assets. Firm size is measured as a natural log of the book value of total assets. Leverage is the ratio of total debt to the book value of total assets.
cash ratio capex ratio leverage firm size
Year Obs. Mean Median Mean Median Mean Median Mean Median
2000 5047 0.1618 0.0827 0.0600 0.0409 0.2066 0.1769 5.1398 5.0597 2001 4943 0.1492 0.0768 0.0596 0.0408 0.2225 0.1967 5.1347 5.0628 2002 4882 0.1477 0.0802 0.0498 0.0328 0.2325 0.2040 5.0769 5.0257 2003 4851 0.1515 0.0847 0.0446 0.0291 0.2346 0.1994 5.0331 4.9796 2004 4880 0.1604 0.0955 0.0458 0.0282 0.2212 0.1844 5.0279 4.9808 2005 4803 0.1650 0.0975 0.0474 0.0290 0.2157 0.1773 5.0637 4.9985 2006 4654 0.1667 0.1001 0.0481 0.0296 0.2099 0.1740 5.1235 5.0492 2007 4365 0.1603 0.0939 0.0485 0.0307 0.2140 0.1824 5.2082 5.1440 2008 4071 0.1465 0.0840 0.0487 0.0301 0.2319 0.1977 5.2508 5.1793 2009 3372 0.1515 0.0983 0.0366 0.0226 0.2274 0.1986 5.3518 5.2929 2010 3535 0.1519 0.0994 0.0341 0.0211 0.2196 0.1867 5.3345 5.2663 2011 3360 0.1429 0.0910 0.0378 0.0240 0.2208 0.1857 5.3551 5.2807 2012 3156 0.1403 0.0900 0.0371 0.0236 0.2228 0.1873 5.3896 5.3141 Total 55919 0.1543 0.0894 0.0470 0.0298 0.2213 0.1881 5.1725 5.1073
In order to show the trend more clearly, the mean and median ratio of cash, capital expenditure and leverage are shown in graph 1 and graph 2.
21
Graph 2 : the median ratio of cash, leverage and investment year by year (2000-2012)
Table 3, together with graph 1 and 2, shows the trend in the mean and median cash ratio in the European sample companies during the period from 2000 to 2012. It can be seen from the figures that the cash holding as a percentage of asset stabilise around 15.0% in the sample period, but there are some fluctuations during financial crisis around 2008. For instance, the mean cash ratio decreases from 16.7% in 2006 to 14.7% in 2008, then increases later from 14.7% to 15.2% in 2010. The changes in the median cash ratios for the sample are similar to mean cash ratio. The firms’ median cash holdings decrease from 10.0% in 2006 to 8.4% in 2008. Later on, it rises up to 9.0% in 2012. Clearly, we can see a gap in both the mean and median ratios around 2008, which is the first year of financial crisis. Afterwards, there is an increase in both, between 2008 and 2010, and a decrease between 2010 and 2012. As a whole, the cash holding experiences a slight decrease during the financial crisis with respect to the period before crisis based, on the sample data. As for these fluctuations, the graph shows a U-shape in the cash holdings ratio during the crisis, which is consistent with the findings of Kahle and Stulz (2013).
TABLE 4
Comparison of Cash ratio in the Period of Pre- versus During-Financial Crisis
Table 4 presents the mean and median cash ratio for the 2 subperiods: pre-crisis (2000–2007) and crisis (2008– 2012). I also report p-values from t-tests for the mean difference and p-values from the Wilcoxon test for the median difference. Here, the cash ratio is the ratio of cash to the book value of total assets.
Mean Median
Variables 2000-2007 2008-2012 P-value 2000-2007 2008-2012 P-value
CASH_RATIO 0.1577 0.1467 0.0000 0.0880 0.0918 0.0504
As can be seen from table 4, the median cash ratio increases while the mean ratio decreases, during the financial crisis, compared with before the crisis. Besides, I also use the t-test to examine whether there is a statistically significant difference, which can be seen from the p-value (1% significance level). Obviously, it confirms the previous result that there is a significant decrease (p-value 0%) in the mean cash ratio, while no significant increase in median cash ratio (p-value 5%).
In conclusion, the mean cash ratio experiences a significant decrease during the financial crisis with respect to the prior period, especially the first year of crisis, namely, 2008. Considering the changes in some factors, like the capital expenditure ratio, the cash ratio also has a fluctuation during the financial crisis. The graphs show a U-shape in the cash holdings ratio during the crisis, which is consistent with the findings of Kahle and Stulz (2013). The result confirms the hypothesis that the cash ratio during financial crisis is significantly different from the cash ratio before financial crisis.
Part B
H2: The change in firm characteristics cannot explain the changes in corporate cash ratio in the financial crisis.
23 TABLE 5
Comparison of Firm Characteristics in the Period of Pre- versus
During-Financial Crisis
Table 5 presents the mean and median firm characteristics for the 2 subperiods: pre-crisis (2000–2007) and during-crisis (2008–2012). I also report p-values from t-tests for the mean difference and p-values from the Wilcoxon test for the median difference. Leverage is the ratio of total debt to the book value of total assets. NWC-to-assets is the ratio of net working capital minus cash to the book value of total assets. Capital expenditure ratio is calculated as the capital expenditures divided by the book value of total assets. The acquisition ratio is measured as the acquisition cost to book value of cash holdings. The EBIT ratio is the ratio of earnings before interests and taxes (EBIT) to the book value of total assets. The market-to-book ratio is calculated as the sum of total debt and the market value of equity, divided by the book value of total assets. The firm size is the natural log of the book value of total assets.
Mean Median
Variables 2000-2007 2008-2012 P-value 2000-2007 2008-2012 P-value
CASH_RATIO 0.1577 0.1467 0.0000 0.0880 0.0918 0.0504 CAPEX_RATIO 0.0506 0.0392 0.0000 0.0325 0.0242 0.0000 ACQU_RATIO 0.0156 0.0113 0.0000 0.0000 0.0000 0.0000 EBIT_RATIO -0.0096 -0.0012 0.0004 0.0541 0.0468 0.0000 FIRM_SIZE 5.0997 5.3323 0.0000 5.0364 5.2623 0.0000 LEVERAGE 0.2197 0.2248 0.0057 0.1865 0.1917 0.0384 M2B_RATIO 1.1054 0.8928 0.0000 0.6542 0.5271 0.0000 NWC_RATIO 0.0158 -0.0056 0.0000 0.0192 0.0012 0.0000
median ratio significantly decreases from 5.4% to 4.7%. Consistent with the pecking order theory and with the free cash flow theory, the leverage is negatively related to the cash ratio, thus, the leverage significantly grows up from 21.9% to 22.5%. Similar to the previous research, due to the fact that some small firms did not survive the financial crisis, the mean(median) firm size change from 5.1(5.0) to 5.3(5.2) with p-value 0%(0%). Lastly, the net mean(median) net working capital ratio, which represents the substitute for liquid assets, significantly decreases from 1.6%(1.9%) to -0.6%(0.1%), with p-value 0%(0%). This result is completely different from the previous research, according to which the cash ratio is negatively related to the net working capital ratio. Therefore, these changes of firm characteristic ratios make the trend of the cash ratio change more complicated.
According to the three different theories, the firm size, capital expenditure ratio, acquisition ratio, market-to-book ratio, net working capital ratio and EBIT ratio, (which undergo a significant change in financial crisis), all make contributions to the fluctuation of the cash ratio. On one hand, some of them have an ambiguous relation with the cash ratio, based on different theories, for example, the firm size, capital expenditure ratio and EBIT ratio. On the other hand, some determinants have a clear positive or negative relationship. For instance, as the net working capital ratio goes down, the cash ratio should grow compared with the ratio before financial crisis. However, the net working capital ratio goes down along with cash ratio, based on the figures in table 5. Therefore, the impact of all firm characteristics on the cash ratio in this case is not clear. To further investigate whether changes in firm characteristics explain the change of cash holdings in the financial crisis period, I will use the regression before the financial crisis to predict the cash ratio during the financial crisis, then compare it with the actual cash ratio during the financial crisis, to see whether there is a significant difference, this method has been used in some previous research, for example Bates et al. (2009).
25 Before I make the comparison, I have to decide the proper regression model. Basically, there are four different models to use, namely, Fama-MacBeth regression, Fixed effect of firms regression, Random effect of firms regression, and also OLS regression. In this case, after the Hauseman test, I find that the fixed effect regression is better than Random effect regression with p-value 0%. Thus, the preference is among three models: Fama-MacBeth regression, Fixed effect regression and OLS regression.
TABLE 6
Estimation of Regressions on Cash Ratios
Table 6 presents the results of regressions on cash ratio for the sample firms. There are three models for the cash ratio regression, namely, models 1, 2 and 3. Specifically, model 1 uses the fixed effect of firms regression based on the result of the Hausman Test; model 2 uses the Fama-MacBeth regression (The coefficients of F-M’s regression are the average coefficients from annual cross-sectional regressions estimated over the period from 2000 to 2007.); model 3 uses the OLS regression. In terms of the ratios below, leverage is the ratio of total debt to the book value of total assets. NWC-to-assets is the ratio of net working capital minus cash to the book value of total assets. Capital expenditure ratio is calculated capital expenditures divided by the book value of total assets. Acquisition ratio is measured as the acquisition cost to book value of cash holdings. EBIT ratio is the ratio of earnings before interests and taxes (EBIT) to the book value of total assets. Market-to-book ratio is calculated as the sum of total debt and the market value of equity, divided by the book value of total assets. Firm size is the natural log of the book value of total assets. Lastly, N is the number of observations used from 2000 to 2007.
Cash ratio
Model 1 Model 2 Model 3
NWC_RATIO -0.12734 -0.160573 -0.159625
(<0.01) (<0.01) (<0.01)
C 0.216039 0.2829738 0.282016
(<0.01) (<0.01) (<0.01)
N 38020 38020 38020
Year dummy Yes
Firm dummy Yes
Adjusted R-squared 0.759 0.287 0.283
As can be seen from table 6, it is easy to find that model 1 has a comparably higher adjusted R-squared value, which suggests that model 1 can better express the relation. Therefore I will choose model 1: fixed effect regression to apply into the regression, it is shown below:
Table 1H
Table 1H presents the signs of predicted regression based on fix effects of firms, and also the signs based on three different theories. The shadow in the table is used to address the same signs.
Regression Trade-off theory Pecking order theory Free cash flow theroy
Firm size - - + + M2B ratio + + + - Capex Ratio - + - NWC ratio - - Leverage - unknown - - EBIT ratio + - +
27 TABLE 7
Predicted Cash Ratios and Their Deviations from Actual Cash Ratio during the
Financial Crisis Period
Table 7 summarises the predicted cash ratios of sample firms for 2000–2007, and deviations of the actual cash ratios from those predicted by FE regression. The cash ratio is measured as the ratio of cash to the book value of total assets. Estimates from the regression are as follow: cash ratio=-0.200199*acquisition_ratio- 0.182677*capex_ratio+0.024324*ebit_ratio-0.001953*firm_size-0.209172*leverage+0.010962*m2b_new_ratio-0.12734*nwc_ratio+0.216039. The table reports the mean predicted cash ratios and the difference between actual cash ratios and predicted cash ratios by year for the whole sample. The numbers in parentheses are p-values from t-tests to test whether the actual minus predicted cash ratios are different from zero.
cash ratio predicted actual actual-predicted p-value
2008 0.153 0.147 -0.006 0.013 2009 0.161 0.151 -0.010 0.000 2010 0.164 0.152 -0.012 0.000 2011 0.161 0.143 -0.018 0.000 2012 0.161 0.140 -0.021 0.000
Conclusion
Cash ratio is one of the most important financial ratios in corporate financial management. The level of cash holding can reflect some operating and financing situations, and meanwhile it is influenced by some micro- and macroeconomic situations. There are plenty of studies that researched this topic, including the determinants of cash ratio, the value of cash ratio, and whether the negative economic shock influences the cash ratio. Based on the previous study, I will focus on the research in Europe and examine whether the financial crisis would impact cash holding levels for European companies. Due to the uniqueness of the Western European companies, compared with U.S. and Asian ones, this paper makes a contribution in the form of a location sample selection, to examine the previous literature.
In order to investigate the impact, I come up with two hypotheses based on the previous research and the financial effects in Europe. Firstly, the cash ratio during the financial crisis is significantly different from before. Secondly, assuming that the demand function of cash holding does not change, the firm characteristics cannot explain the cash ratio during the financial crisis.
By using the data from 2000 to 2012 in European companies, I find that the cash ratio during the financial crisis undergoes some fluctuations. Meanwhile, it significantly decreases in the financial crisis, compared with before, especially in the first year of financial crisis, 2008. This significant difference is consistent with my expectation and with previous studies. As for the fluctuation, two graphs show a U-shape cash holdings ratio during the crisis, which is consistent with the findings of Kahle and Stulz (2013). Apart from that, I also find that the firm characteristics cannot explain the cash ratio during financial crisis by comparing the predicted cash ratio and actual ratio, and this result is consistent with Song and Lee (2012).
29 some popular determinants, which already have been used before, and eliminate some determinants due to difficulties in the data or analysis, for example, dividend payments.
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