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MSc Finance Thesis
The Relationship Between Cash Holdings and
Firm Profitability:
A Comparative Analysis of Common- and Civil-Law Countries
By: Christopher Timmerman – S2712202
Supervisor: prof. dr. R. E. Wessels
2 Abstract: By using a sample of 3,559 firms from seven countries, this paper researches the
relationship between cash holdings and firm profitability. The differences between common- and civil-law systems are considered in this relationship as well. OLS and seemingly unrelated regressions (SUR) are estimated to complete this research. The results indicate that the size of cash holdings are negatively related to firm profitability at the 1% significance level with this relationship being more negative in civil-law countries. The negative relationship between cash and profitability is upheld when estimated by SUR. Furthermore, a negative conditional, and unconditional, correlation between cash and profitability shows that cash holdings are not optimally determined and that, on average, firms hold cash above the optimal level.
Keywords: Corporate Governance, Cash Management, Capital Investments, Corporate Profitability JEL Classification: G31, G32 and G34
3 1: Introduction
This thesis researches how cash holdings are related to firm profitability and how differing legal systems affect this relationship. This topic of research was chosen because the average amount of cash holdings is growing every year. Sanchez and Yurdagul (2013) reported that increases in corporate cash holdings grew at an annual rate of ten percent between 1995 and 2011. This growth in cash holdings is occurring despite large cash holdings being a common area of conflict between shareholders and managers (Jensen, 1986; Harford et al, 2008). Conflicts on how to manage cash arises given its many uses. Managers may want to hold more cash to avoid liquidity risk or exploit sudden investment opportunities. Alternatively, shareholders may want management to issue dividends or invest with the cash rather than holding onto it as cash earns a lower rate of return.
Corporate governance helps firms manage areas of conflict such cash management by implementing rules, procedures, and relations that bring structure to firm decision making. However, corporate governance varies between firms and depends on the legal system of the firm’s country. This paper focuses on common- and civil-law systems. Common-law countries are characterized as having strong shareholder rights and rely on large, well-developed financial markets to monitor managers. Alternatively, civil-law countries exhibit weaker shareholder protection and rely on close relationships and concentrated ownership (Moerland, 1995; La Porta et al, 1998). Given these differences, legal systems provide a valuable source for comparative analysis.
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al (2008) find that firms with weak shareholder rights have lower profitability. Profitability is even lower when firms hold more cash and have weak shareholder rights.
To research if cash is managed optimally, this paper looks at how cash relates to profitability. Also, since legal system is a determinant of how cash is managed, this research aims to answer the following questions: What is the relationship between cash and profitability?
How does this relationship differ between common- and civil-law countries? Do firms optimally determine their cash holdings?
1.1: The structure of this research
This paper uses data gathered from 3,559 companies from seven countries over five years to examine how cash holdings are related to firm profitability and whether cash holdings are optimally determined. First, the relationship between cash and profitability is estimated using OLS regressions. Interaction terms between a legal system dummy and each explanatory variable show the incremental effect of civil- and common-law on the relationship of cash and profitability. The countries from common-law systems are the UK and US. Civil-law countries include Belgium, France, Germany, Luxemburg and the Netherlands. Next, endogeneity of cash holdings and profitability is accounted for by estimating a seemingly unrelated regression (SUR). This differs from the existing literature where endogeneity is either ignored or considered using lagged or instrumented variables.
By estimating an OLS regression, it is found that the size of cash holdings is significantly negatively related with firm profitability at 1% significance level. Furthermore, the relationship is more negative for firms in civil-law countries than firms in common-law countries. Estimation of SUR also shows that there is a significant negative relationship between cash holdings and profitability. Because there is a correlation between both variables, it is concluded that cash holdings are not optimally determined and, on average, firms hold too much cash. Firm managers can use these findings to help make decisions on cash holdings. In addition, because cash and profitability are endogenous, managers need to be aware that optimal levels are not achieved by altering one or the other directly, but rather by adjusting exogenous firm variables.
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model. Section 5 concludes with a brief review, a discussion of the results, contributions and limitations of this study and suggestions for further research.
2: Literature Review 2.1: Agency Theory
Before company ownership became dispersed, it was often concentrated with the entrepreneur functioning as both ownership and control. Moerland (1995) argues that companies began dispersing ownership to emphasize scale economies, specialize in managerial capabilities and diversify shareholder risk. Along with these benefits however, came agency problems. The focus on the classic closely-owned firm shifted to the more dispersedly-owned corporation when Jensen and Meckling (1976) first built a framework for agency theory.
Jensen and Meckling (1976), generalize the corporation as a “nexus of contracts” and conflicts of interest are formed from these contractual agreements. These conflicts can be expected when both parties in the contractual relationship are utility maximizers, as it is likely that the agent and principal will not have identical utility curves and thus agents will not always act in the best interests of the principal (Jensen and Meckling, 1976). As the agent’s fraction of equity falls, he may be inclined to give himself perquisites or spend corporate resources in a way that maximizes his utility but not the utility of shareholders. This makes the shareholders now the residual claimant and they will have to provide incentives as well as discipline on the management to manage the agency costs. In addition, they will pay less for the shares when they realize interests are unaligned and monitoring costs are present.
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The term “market for corporate control” gathered attention in the late 20th century, as it was featured in a variety of papers that focus on the agency theory of the market (Fama and Jensen, 1983; Jensen and Ruback, 1983; Manne, 1965). Jensen and Ruback (1983) view the market for corporate control “as the arena in which management teams compete”. This considers management teams that compete as primary activist entities; the stockholders have a passive, but important judicial role. This competition for the right to manage corporate resources helps managers act to maximize shareholder wealth.
Fama and Jensen (1983), examine “the survival of organizations in which important decision agents do not bear a substantial share of the wealth effects of their decisions”. When owners, are not qualified to make decisions, they delegate the decision-making to an agent with expertise. This specialization of management in decision-making is one reason for success of the publicly owned corporation, but it introduces the agency cost of decision agents not bearing all the risk of their decisions. Fama and Jensen find that survival of the public corporation is achieved by firms all following a common method of controlling agency problems, which is to separate the ratification and monitoring of decisions from the initiation and implementation of the decisions. Fama and Jensen group the ratification and monitoring activities into “decision control” and initiation and implementation into “decision management”. Decision control is typically completed by a board of directors or shareholders, whereas decision management applies to top management of the firm. By having such a control procedure, decision managers are more prone to act in a way that does not satisfy the interests of residual claimants (Fama and Jensen, 1983).
2.2: Legal Systems and Corporate Governance
With a background on agency theory in modern corporations, this section focuses on how corporate governance and management of agency costs can differ between legal systems. Shareholder protection, outside monitoring by markets, and close relationships are examples of disciplinary mechanisms that help manage agency costs and benefits. The primary disciplinary mechanism used depends on a firms’ national legal system.
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for firms to raise capital. La Porta et al (1998) focus on two legal-traditions of common and civil law. The former is associated with countries such as the US and UK, and the latter with Western Europe. While they find that common law provides the strongest protection of shareholders, in civil law the countries differ. Germanic law exhibits stronger protection than French law, but still is weaker than in the common law countries. Ultimately, La Porta et al (1998) show that shareholder rights are not inherent in securities, but rather are determined by legal systems and firms handle this on an individual basis.
La Porta et al (2000) conclude that legal protection may be better at describing differences than other descriptions such as market-centeredness, ownership concentration, and access to external finance. While these are important, it is likely that these differences are rooted in how much shareholder protection is provided by the common- and civil-law legal systems. When country legal systems exhibit weak investor protection, they compensate with mechanisms such as ownership concentration and legal reserve requirements. La Porta et al (2000) find that with strong shareholder protection, investors are willing to pay more for financial assets. Firms in countries with strong shareholder protection are therefore more willing to raise capital externally thus expanding financial markets. This helps explain why common-law countries such as the UK and US are characterized by large, robust capital markets. Alternatively civil-law countries, such as those in Western Continental Europe, are more concentrated in ownership (Moerland, 1995).
Moerland (1995), wrote about the country-differences in governance systems prior to La Porta et al, however he was differentiating between the countries at a level deeper than legal systems. Moerland refers to the governance of the UK and US as being market-oriented. Given the vast liquid capital markets of these countries and high quality investor protection, the market for corporate control brings the threat of hostile takeovers to keep management in line with investors (Moerland, 1995). Furthermore, the labor market is extensive enough that replacement of awry managers is easily completed.
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and managers are handled differ as well. The market-oriented system relies more often on discipline via market interventions, whereas in the network-oriented system relies on insiders and a closely knit group of monitors to implement discipline (Moerland, 1995).
De Jong (1991) researches the takeover markets of countries often grouped together as Germanic and Latin countries. In Germany, most companies have financial institutions as majority shareholders. These institutions influence companies by either possessing seats in the company’s board of directors or proxy voting. The Netherlands has hostile takeovers via buying shares, however in the past there was the case of the acquirer not having a say in the boardroom and will cause a deadlock in management. In France, family control and state ownership dominate. Growing availability of information helps promote takeover market and changes in French law have made for a more hospitable system for takeovers, however it is not nearly as widespread as in the UK or US. Belgium and France both exhibit few takeover bids. In Belgium, the companies generally have very little equity offered to the public so that the majority of ownership is kept close to the company. According to De Jong (1991), the main reason the takeover market is so active in the UK and US is that they view the concept of the corporation differently. Unlike in continental Europe where the corporation is viewed “as a balance of various interests led by an oligarchic group”, the UK and US see the corporate system “as a combination of managerial directors working to benefit shareholders” (De Jong, 1991).
Franks and Mayer (1990) reinforce the previously mentioned strength of the takeover market. They argue that takeovers assist in correcting manager failures that can be hard to fix otherwise. This is an advantage for the market-oriented system over its counterpart. However, Franks and Mayer (1990) argue that takeovers can undermine contractual relations citing that “long-term contracts are hard to sustain and reputations for maintaining informal arrangements easy to extinguish”. By constantly changing ownership, this can make benefits of long term relationships hard to achieve. These downsides of the market for corporate control can cause short-termism in company management that will ruin long run shareholder wealth in common-law firms.
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The risk of objectivity is that monitoring can be ex-post and evaluative, rather than ex-ante and pro-active (Franks and Mayer, 1990; Boot et al, 2005). In Europe, proximity is the effective component of their network-oriented system. Through having concentrated ownership made from close-knit relationships, trust and fast access to information help principals monitor agents. However, when relationships are long-lasting, there is the risk of the monitor losing independence and thus the manager may not act on all investors’ best interests.
2.3: Cash, Investment Decisions and Corporate Governance
Given the differences between the corporate governance systems, there can be efficiencies that one has over the other in monitoring management to have shareholder interests respected. One of the most important areas to shareholders that is under control of management is the management of cash. Previous research explains how managers can manage and deploy cash holdings optimally to improve the value and profitability of the firm. Additionally, it has been shown that corporate governance affects the cash decisions managers make.
Jensen (1986) ties agency costs, free cash flow and takeovers together in his research. He summarizes free cash flow as “cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital” (Jensen, 1986). Free cash flows allow managers to finance projects internally with cash rather than relying on external financing and thus they surpass monitoring from the external market. External financing would not rationally be obtained for projects with negative net present values. With free cash flows, external financing is not needed and making it possible for managers to invest in negative net present value projects. Managers would invest in such projects when there are wealth benefits for themselves, despite the lack of wealth benefits for shareholders. Often these projects are the product of short-termism or empire-building. Jensen finds that takeovers are both the problem and the solution to this agency cost of free cash flows. Acquisitions that occur through empire building are typically focused on increasing power of the management and destroy shareholder wealth. However, when there is free cash flow that is not being used to satisfy shareholders, the management becomes a quick target for a disciplinary takeover (Jensen, 1986).
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or investments because of a liquidity premium as well as tax disadvantages. The benefits are avoiding transaction costs associated with raising funds and having readily available and liquid assets to finance activities and investments. When there is focus on the tradeoffs between the costs and benefits of cash holdings, it is then possible to know if a firm holds too much cash from a perspective of maximizing shareholder wealth (Opler et al, 1999). Since agency theory focuses on the costs and benefits of cash holdings, Opler et al (1999) states that “agency theory can explain why firms do not hold the amount of cash that maximizes shareholder wealth, and help to identify firms that are likely to hold too much cash.” For example, the benefit of having liquid assets on hand to help finance unexpected investments is caused by a manager’s desire to be precautionary and reduce risk. If managerial discretion is stressed as important in a company, there is then an agency cost of holding too much cash and not maximizing shareholder wealth (Opler et al, 1999). The costs and benefits of cash holdings vary based on firm characteristics such as access to capital markets, riskier cash flows and higher growth opportunities. These characteristics thus affect the way managers handle cash and can affect the degree to which agency costs are heeded.
The optimal use of cash and investments is further researched by Inci, Lee and Suh (2011), with a focus on capital investment and profitability. Their findings support the free cash flow hypothesis of Jensen (1986) as large availability of earnings leads to larger capital investment in countries with low-insider ownership. This means these cash flows lead to empire-building behaviors and less profitable projects. Additionally they find that capital investments are neither strong nor positively associated with profitability in many countries, thus signaling that managers are investing in less than optimal projects. Furthermore, they find that capital investments are positively related to profitability in common law countries such as US or UK, and the opposite is true for civil law countries (Inci et al, 2011). This is in line with La Porta et al (1998), a study mentioned previously in the literature review, in which they found stronger shareholder protection in common law countries in comparison to civil law countries.
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firm value (Harford et al, 2008). Large cash reserves, if visible, make firms a target for attack by the takeover market given the agency costs of cash management practices (Opler et al, 1999; Harford et al, 2008).
In addition to the problems of managerial discretion, another problem in corporate governance arises between the shareholders. Pinkowitz, Williamson and Stulz (2006) focus on firms where majority shareholders can divert cash from minority shareholders over to themselves. This issue becomes more relevant in the civil-law system where concentration of ownership is more prevalent. The research finds evidence of investors discounting the assets of companies in countries of weak investor protection because they expect to never reap the full benefits of the assets (Pinkowitz et al, 2007).
2.4: Hypotheses
The goal of this paper is to examine the relationship between firm profitability and cash holdings, as well as examine how legal systems affect this relationship. Therefore, the following null hypotheses are formed:
H0,A: The relationship of cash holdings and profitability does not differ between firms
from civil- and common-law countries. H0,B: Firms hold the optimal amount of cash.
3: Empirical Model
Section 3 discusses the motivation behind the selection of variables. Next, some descriptive statistics are presented. Lastly, the empirical model used to test the hypotheses is presented. This includes OLS and seemingly unrelated regressions. The issue of endogenous variables is addressed when discussing the seemingly unrelated regression. This research uses pooled cross-sectional analysis rather than panel data analysis because the dataset has missing values and is unbalanced.
3.1: Variable Selection
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assets and EBITDA (earnings before interest, tax, depreciation, and amortization) margin. Return on assets is used because it is well known and shows the firm’s ability to generate profits from its total resources, their total assets. The EBITDA margin is used because it gives a measure of operating profitability. The measures are calculated as:
The two cash variables used are cash to sales and cash to assets and are taken from previous research (Opler et al, 1999; Harford et al, 2008). The cash variables are calculated as:
Research and development, capital expenditures and acquisitions are used as a proxy for a firm’s investments. The cash, only in the OLS regression, and investment variables are lagged by one year behind profitability to help deal with endogeneity issues. Section 3.3 explains endogeneity further. These variables are also taken from Opler et al (1999) and Harford et al (2008) and are lagged just as Harford does to help with endogeneity.
A legal system dummy is used which takes on a value of 0 when a firm is located in a civil law country and a value of 1 when located in a common law country. The civil law countries in the sample are Belgium, France, Germany, Luxemburg, and Netherlands. The common law countries are United Kingdom and United States. This dummy is multiplied with the explanatory variables to create interaction terms that show the incremental effect of being located in a specific legal system.
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Firm size is controlled for because a larger firm will likely have a larger cash holdings or investments to sustain itself compared to smaller firms. On the other hand, larger firms may have smaller cash holdings because they have greater access to capital markets (Opler et al, 1999). Liquidity is controlled for as firms may use liquid assets to protect themselves against losses or as securitization rather than cash. Growth opportunities can affect the cash holdings and investments as those with greater growth opportunities will hold more cash and invest more to exploit these opportunities (Opler et al, 1999). Lastly, leverage is used as a control for firm risk.
3.2: Descriptive Statistics
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Table 1: Descriptive Statistics
Total Sample Belgium France Germany Luxemburg Netherlands UK US
N = 3559 n = 27; 0.76% n = 231; 6.49% n = 284; 7.98% n = 6; 0.17% n = 63; 1.77% n =318; 8.94% n = 2630; 73.90%
Common/Civil Law Civil Civil Civil Civil Civil Common Common
Med. Mean St.
Dev Med. Mean St.
Dev Med. Mean St.
Dev Med. Mean St.
Dev Med. Mean St.
Dev Med. Mean St.
Dev Med. Mean St.
15 3.3: OLS Regression
The first model used to analyze the relationship between profitability and firm cash holdings is an OLS multivariate model. Four equations are estimated using two different profitability measures and two different cash measures. The model is presented in equations 1 to 4 below:
Where ROA is return on assets, EBITDA is EBITDA margin, CashS is the cash-to-sales ratio, DLS is a legal system dummy, RD is research and development, CapEx is capital
expenditures, Acq is acquisitions, Size is the natural logarithm of total assets, WC is working capital excluding cash over net assets excluding cash, MB is the market to book ratio, Lev is the leverage calculated as debt to equity ratio, and CashA is the cash-to-sales. The legal system dummy takes on the value of 0 when the firm is located in a civil law country and 1 when the firm is located in a common law country.
The legal system dummy is multiplied by the explanatory variables to create interaction terms. These interaction terms help estimate the incremental effect a legal system has on the relationship between explanatory variables and profitability.
16 3.4: Seemingly Unrelated Regression
When using multiple variables in a regression originating from a company’s financial statements, endogeneity can occur given the structure of double-entry bookkeeping. Double-entry bookkeeping results in having accounting variables that are contemporaneously codetermined. If there are accounting variables present on both sides of the regression equation, then OLS estimators may yield biased results (Christodoulou and McLeay, 2009). Because I use accounting variables on the right and left hand sides of the regression equations, I must be aware of endogeneity in my data.
Endogeneity occurs when an explanatory variable is also a dependent variable causing correlation between this explanatory variable and the error term. Endogeneity can arise from measurement error, omitted variables, and joint determination. For example, while assuming that the profitability is determined by the cash holdings of the firm, it is likely that cash holdings are determined by the profitability of the firm as well. Because the variables are jointly determined, endogeneity is present and introduces bias and inconsistency to the estimated OLS regression coefficients. A more efficient way to estimate the relationship of profitability with cash is jointly estimate them using a simultaneous-equations model such as the seemingly unrelated regression (Zellner, 1962). When jointly estimating the equations, the error terms are allowed to be correlated and a variance-covariance matrix of the coefficients is estimated (Stata 13 Manual). The sureg command in Stata estimates the correlation of residuals which verifies the relationship of profitability and cash.
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18 4: Results
Section 4.1 presents the results of the OLS conditional and unconditional regressions and Section 4.2 presents the results of the seemingly unrelated regressions.
4.1: OLS Regression Results
The results of the OLS regressions in tabular form are available at the end of this section in Table 2 and Table 3. The first OLS results are an unconditional estimation, which omits the dummy and interaction variables. The second OLS results do include the dummy and interaction variables. These regressions show the impact of cash holdings and investments on profitability. The R-squared for each regression is low which means that the goodness-of-fit of the regressions is poor. This means there are missing variables that need to be included in order to increase the goodness-of-fit of the regression.
The first finding of the unconditional OLS regression, which excludes the law dummy and interaction variables, is that cash holdings and profitability have a negative relationship at the 1% significance level in each of the regressions. Because the variables are standardized we can interpret the regressions coefficients as follows: one standard deviation increase in X increases, on average, Y by one standard deviation times the beta coefficient of X. For example, an increase of one standard deviation in cash over sales, decreases return on assets, on average, by -0.224 (or -22.4%) of one standard deviation. The standard deviation can be found in Table 1.
Relevant literature supports the finding that having larger cash holdings can increase the chance of managers making less profitable decisions. This is because the amount of cash held may be beyond that which is needed to be spent for maintaining the business. These free cash flows can be used to increase the amount of assets under managements’ control and increase their discretion (Jensen, 1986). This can lead to investments related to empire-building that have lower returns (Inci et al, 2009; Harford et al, 2008).
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used for estimation, the civil-law firms’ cash holdings are found to be significantly more positively related to profitability than common-law firms. The difference in slope can be calculated by subtracting the interaction term coefficients from each other. For example, when ROA and cash over sales are used for estimation, the difference in slope is -0.081 (= -0.294-(-0.213)). This means that one standard deviation increase in cash over sales, decreases ROA by 8.1% of a standard deviation more if the firm is located in a civil law nation than if located in a common law nation. Because of these results we can reject Hypothesis0,A: the relationship of
cash holdings and profitability does not differ between firms from civil- and common-law countries.
This finding implies that firms are less profitable when holding large amounts of cash when located in civil-law countries in comparison to firms in common-law countries. Relevant literature supports this finding, which finds that firms in countries with weaker shareholder protection hold more cash and invest in low or negative net present value investments (Dittmar et al, 2003; Inci et al, 2011).
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Table 2: Unconditional OLS Regressions
ROAt EBITDAt ROAt EBITDAt
Constant 0.158 [0.015]*** 0.117 [0.018]*** 0.154 [0.017]*** 0.096 [0.025]*** Cash/Salest-1 -0.224 [0.044]*** -0.600 [0.089]*** - - - - Cash/Assetst-1 - - - - -0.104 [0.030]*** -0.326 [0.095]*** R&Dt-1 0.046 [0.004]*** 0.044 [0.004]*** 0.043 [0.004]*** 0.036 [0.003]*** CapExt-1 -0.007 [0.006] -0.010 [0.005] -0.007 [0.006] -0.008 [0.006] Acqt-1 0.006 [0.004] 0.006 [0.003]* 0.005 [0.004] 0.004 [0.003] Sizet -0.002 [0.007] -0.014 [0.006] 0.002 [0.007] -0.004 [0.007] WCt 0.202 [0.050]*** -0.033 [0.077] 0.257 [0.059]*** 0.111 [0.108] MB Ratiot -0.021 [0.024] -0.010 [0.013] -0.015 [0.024] 0.006 [0.015] Leveraget 0.013 [0.017] -0.003 [0.016] 0.026 [0.019] 0.013 [0.029] N= 2921 2837 2927 2841 R-Squared 0.181 0.474 0.127 0.185 F-Test 26.05*** 21.27*** 24.51*** 24.27***
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Table 3: OLS Regressions
ROAt EBITDAt ROAt EBITDAt
Constant 0.154 [0.017]*** 0.096 [0.025]*** 0.159 [0.015]*** 0.118 [0.018]*** LS*Cash/Salest-1 Civil -0.294 [0.057]*** -0.433 [0.038]*** - - - - Common -0.213 [0.051]*** -0.633 [0.005]*** - - - - Difference -0.081 0.200 - - LS*Cash/Assetst-1 Civil - - - - -0.338 [0.114]*** -0.384 [0.103]*** Common - - - - -0.094 [0.031]*** -0.323 [0.099]*** Difference - - -0.244 -0.061 LS*R&Dt-1 Civil 0.022 [0.006]*** 0.022 [0.005]*** 0.025 [0.006]*** 0.026 [0.005]*** Common 0.044 [0.004]*** 0.038 [0.004]*** 0.046 [0.005]*** 0.046 [0.005]*** Difference -0.022 -0.016 -0.021 -0.020 LS*CapExt-1 Civil -0.028 [0.007]*** -0.011 [0.008] -0.027 [0.007]*** -0.013 [0.007] Common -0.004 [0.006] -0.008 [0.006] -0.004 [0.006] -0.010 [0.006]*** Difference -0.024 -0.003 -0.023 -0.003 LS*Acqt-1 Civil 0.005 [0.010] 0.007 [0.006] 0.006 [0.009] 0.008 [0.006] Common 0.006 [0.004] 0.004 [0.002] 0.006 [0.009] 0.006 [0.003] Difference -0.001 0.003 0.00 0.002 Sizet 0.007 [0.007] -0.003 [0.007] 0.003 [0.007] -0.012 [0.006]*** WCt 0.261 [0.059]*** 0.112 [0.109] 0.207 [0.051]*** -0.055 [0.079] MB Ratiot -0.013 [0.024] 0.006 [0.015] -0.021 [0.024] -0.012 [0.013] Leveraget 0.024 [0.019] 0.013 [0.029] 0.014 [0.017] -0.005 [0.016] N= 2927 2841 2921 2837 R-Squared 0.132 0.185 0.184 0.480 F-Test 23.64*** 22.01*** 26.23*** 29.01***
22 4.2: Seemingly Unrelated Regression Results
This section presents the SUR results and the estimated variance-covariance matrices at the end of this section in Tables 4 and 5. The estimates of the interaction variables are all insignificant except for the common law coefficients of R&D. Insignificance does not allow me to make conclusions on differences between legal systems, thus Hypothesis0,A cannot be rejected,
All control variables are significantly negatively related to cash holdings at the 1% significance level. Thus, firms that are larger, possessing more liquid assets besides cash, or have more growth opportunities all hold relatively less cash. Furthermore, only working capital is positively related to profitability.
The Breusch Pagan coefficients, correlations and variance-covariance matrices of the residuals are presented at the end of the tables. The Breusch-Pagan tests a null-hypothesis that the error terms have a correlation of 0. The Breusch-Pagan null-hypothesis is rejected for all regressions at the 1% significance level and therefore the error terms are conditionally correlated. Each of the covariances between the cash and profitability measures are significantly negative and thus the correlations are negative as well. The conditional negative correlation between cash holdings and profitability provides evidence that cash holdings are not optimally determined and that a decrease in cash held, on average, can increase profitability. This is shown on the following page in Graph 1; where on average firms sit to the right of the maximum of the curve.
Graph 1: Relationship between cash and profitability
Firms would hold the optimal amount of cash when an increase or decrease in cash would lower profitability. Hypothesis0,B can be rejected and thusfirms do not hold the optimal amount
of cash. Furthermore, because cash holdings and profitability are endogenous, a firm cannot
simply manipulate its cash holdings to increase profitability, as these are codetermined. Instead, for a firm to reach an optimal level and increase profitability it would need to adjust some exogenous parameters of cash in a way that reduces cash holdings.
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Table 4a: Seemingly Unrelated Regression using Cash/Sales
SUR Model 1 SUR Model 2
ROAt Cash/Salest EBITDAt Cash/Salest
Constant 0.142 [0.010]*** 0.057 [0.012]*** 0.080 [0.011]*** 0.061 [0.012]*** LS*R&Dt-1 Civil 0.021 [0.019] 0.013 [0.024] 0.019 [0.021] 0.011 [0.023] Common 0.040 [0.010]*** 0.029 [0.013]** 0.029 [0.011]*** 0.028 [0.012]** Difference -0.019 -0.016 -0.010 -0.017 LS*CapExt-1 Civil -0.027 [0.021] 0.004 [0.025] -0.018 [0.022] 0.002 [0.024] Common -0.003 [0.014] -0.007 [0.017] -0.005 [0.015] -0.007 [0.017] Difference -0.024 0.011 -0.013 0.009 LS*Acqt-1 Civil 0.006 [0.024] 0.001 [0.030]** 0.007 [0.026] 0.003 [0.029] Common 0.010 [0.009] -0.007 [0.012] 0.012 [0.010] -0.008 [0.011] Difference -0.004 0.008 -0.005 0.011 Sizet 0.015 [0.015] -0.049 [0.019]*** 0.017 [0.016] -0.047 [0.018]*** WCt 0.335 [0.020]*** -0.594 [0.025]*** 0.349 [0.022]*** -0.637 [0.024]*** MB Ratiot -0.008 [0.010] -0.049 [0.013]*** 0.017 [0.012] -0.045 [0.013]*** N= 2922 2922 2838 2838 R-Squared 0.113 0.172 0.089 0.200 Correlation of residuals -0.282 -0.650 Breusch-Pagan (Chi2) 231.683*** 1199.599***
*** significant at 0.5% level, ** significant at 2.5% level, * significant at 5% level. These significance levels are determined using a Bonferroni Correction that divides the original significance levels by the number of hypotheses, 2, being tested. Coefficients are given first and the robust standard errors are presented in parentheses
Covariances of Residuals:
ROA Cash/Sales EBITDA Cash/Sales
ROA 0.211 EBITDA 0.246
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Table 4b: Seemingly Unrelated Regression using Cash/Assets
SUR Model 3 SUR Model 4
ROAt Cash/Assetst EBITDAt Cash/Assetst
Constant 0.140 [0.010]*** 0.075 [0.012]*** 0.072 [0.011]*** 0.064 [0.012]*** LS*R&Dt-1 Civil 0.021 [0.020] 0.015 [0.023] 0.018 [0.023] 0.012 [0.023] Common 0.040 [0.010]*** 0.028 [0.012]** 0.029 [0.012]** 0.027 [0.012]** Difference -0.019 -0.013 -0.011 -0.015 LS*CapExt-1 Civil -0.027 [0.021] 0.026 [0.025] -0.019 [0.024] 0.025 [0.024] Common -0.003 [0.014] -0.007 [0.017] -0.005 [0.016] -0.007 [0.017] Difference -0.024 0.033 -0.014 0.032 LS*Acqt-1 Civil 0.006 [0.024] 0.001 [0.029]** 0.006 [0.028] 0.003 [0.029] Common 0.010 [0.009] -0.023 [0.011] 0.013 [0.011] -0.022 [0.011] Difference -0.004 0.024 -0.007 0.025 Sizet 0.016 [0.015] -0.069 [0.018]*** 0.019 [0.017] -0.065 [0.017]*** WCt 0.335 [0.020]*** -0.751 [0.024]*** 0.355 [0.024]*** -0.747 [0.024]*** MB Ratiot -0.008 [0.010] -0.038 [0.012]*** 0.018 [0.012] -0.032 [0.013]** N= 2928 2928 2842 2842 R-Squared 0.112 0.267 0.082 0.261 Correlation of residuals -0.133 -0.336
Breusch-Pagan Test (chi2) 51.935*** 320.030***
*** significant at 0.5% level, ** significant at 2.5% level, * significant at 5% level. These significance levels are determined using a Bonferroni Correction that divides the original significance levels by the number of hypotheses, 2, being tested. Coefficients are given first and the robust standard errors are presented in parentheses
Covariances of Residuals:
ROA Cash/Assets EBITDA Cash/Assets
ROA 0.216 EBITDA 0.280
26 5: Conclusion
This thesis researches the relationship between cash holdings and profitability as well as the impact of legal systems on this relationship. Data is gathered from 3,559 publicly traded firms in seven different countries, with 83% of firms being domiciled in common-law countries. Observations span from 2011-2015.
First, an OLS regression is estimated using a profitability measure as the dependent variable, and cash, research and development, capital expenditures and acquisitions as explanatory variables. Additionally, the explanatory variables are interacted with a legal system dummy to show the incremental difference of legal systems on the relationships between the explanatory and dependent variables.
Second, a seemingly unrelated regression (SUR) is estimated as well to deal with the endogeneity issues present when examining the relationship between cash and profitability. The SUR model has two reduced form equations, with profitability and cash measures each as a dependent variable and identical right hand sides. The OLS regression and SUR are repeated using two profitability measures and two cash measures. These include return on assets, EBITDA margin, cash over net assets excluding cash, and cash and short term investments over net sales.
This paper initially finds that profitability is negatively related to cash holdings at the 1% significance level when estimated by OLS. Furthermore, when the legal system dummy is interacted with cash in the OLS regression, firm profitability of civil-law firms is more negatively related at the 1% significance level to cash holdings than that of common-law firms. This finding infers that civil-law firms are less profitable than common-law firms when holding large cash holdings. This could be caused by managers facing fewer consequences for inefficient management when shareholder protection is weak. This more negative relationship for firms having lower shareholder rights and excessive cash is supported by Harford et al (2008).
27
close-connected banks (La Porta et al, 2000). This finding is a reason for concentration of ownership in civil-law nations.
Next, this paper finds that cash holdings are not optimally determined by firms. The SUR estimations find a negative conditional correlation between all the cash and profitability measures. This finding confirms the negative relationship found using OLS. Furthermore, the negative correlation estimated by the SUR indicates that, on average, firms can bolster profitability by lowering their cash holdings. Because of endogeneity, a firm cannot simply lower cash holdings to an optimal level in order to increase profitability, rather the firm should adjust exogenous parameters of cash accordingly to bring cash to the optimal level.
This research adds to the existing literature, as there have been few attempts at estimating the relationship between cash and profitability while considering different legal systems. Furthermore, literature often uses governance scores to help pinpoint differences in cash management, rather than focusing on legal systems. The use of governance scores, while useful, can be less than ideal as they are more qualitative measures and scaling them can be subjective. Because governance depends on the legal system of the country, as shown by La Porta et al (2000), it should be possible to complete a comparative analysis by comparing countries from differing legal systems. Additionally, the use of a SUR to deal with endogeneity issues has not previously been applied to the topic of cash and profitability’s relationship.
28 6: References
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Christodoulou, D., McLeay, S., 2009. Using Accounting Information in Econometric Models. Presentation. University of Sydney.
De Jong, H., 1991. The takeover market in Europe: Control structures and the performance of large companies compared. Review of Industrial Organization 6, 1-18.
Dittmar, A., Mahrt-Smith, J., 2007. Corporate governance and the value of cash holdings. Journal of Financial Economics 83, 599-634.
Dittmar, A., Mahrt-Smith, J., Servaes, H., 2003. International corporate governance and corporate cash holdings. Journal of Financial and Quantitative Analysis 38, 111-133. Fama, E., 1980. Agency problems and the theory of the firm. Journal of Political Economy 88,
288-307.
Fama, E., Jensen, M., 1983. Separation of ownership and control. Journal of Law and Economics 26, 1-31.
Franks, J., Mayer, C., 1990. Takeovers: Capital markets and corporate control: A study of France, Germany, and the UK. Economic Policy 5 (1), 189-231.
Harford, J., Mansi, S., Maxwell, W., 2008. Corporate governance and firm cash holdings in the US. Journal of Financial Economics 87, 535-555.
Inci, A., Lee, B., Suh, J., 2009. Capital investment and earnings: International evidence. Corporate Governance: An International Review 17 (5), 526-545.
Jensen, M., 1986. Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review 76, 323-329.
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Jensen, M., Ruback, R., 1983. The market for corporate control: The scientific evidence. Journal of Financial Economics 11, 5-50.
La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R., 1998. Law and Finance. Journal of Political Economy 106, 1113-1155.
La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R., 2000. Investor protection and corporate governance. Journal of Financial Economics 58, 3-27.
Lee, B., Suh, J., 2011. Cash holdings and share repurchases: International evidence. Journal of Corporate Finance 17, 1306-1329.
Manne, H., 1965. Mergers and the market for corporate control. Journal of Political Economy, April, 110-120.
Moerland, P., 1995. Alternative disciplinary mechanisms in different corporate systems. Journal of Economic Behavior and Organization 26, 17-34.
Moerland, P., 1995. Corporate ownership and control structures: An international comparison. Review of Industrial Organization 10, 443-464.
Opler, T., Pinkowitz, L., Stulz, R., 1999. The determinants and implications of corporate cash holdings. Journal of Financial Economics 52, 3-46.
Pinkowitz, L., Williamson, R., Stulz, R., 2007. Cash holdings, dividend policy, and corporate governance: A cross-country analysis. Journal of Applied Corporate Finance 19, 81-87 Powell G., Kent Baker, H., 2010. Management views on corporate cash holdings. Journal of
Applied Finance 2, 155-168.
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30
Shleifer, A., Vishny, R., 1997. A survey of corporate governance. The Journal of Finance 52, 737-783.
31 Appendix
A.1: Data Description
The gathering of data began by making a list of active, publicly traded companies located in Belgium, Netherlands, Luxemburg, France, Germany, UK, and USA. These countries were chosen based on availability of firm data and because they are used in relevant studies that compare governance and legal systems (Moerland, 1995; La Porta et al, 1998; Inci et al, 2009). To avoid cross-border influence in the regulation and governance of firms, no firms are included that are listed on a market whose country is different from the firm’s domiciled country. Additionally, all financial and utility companies are excluded, as previous research has done. This is because it is difficult to measure the level of liquidity of financial firms, and heavy regulation of the utilities sector can influence the governance and liquidity of utility firms (Dittmar and Mahrt-Smith, 2007). Furthermore, companies that are inactive from 2010 onwards are excluded in order to fit the timeframe of 2011-2015. This initial sample was collected via Orbis.
In order to collect the firms’ financial data, an identifier that was used by both Orbis and databases containing financial information on transactions was needed, thus the international securities identification numbers (ISIN) are used. The first database used to collect the data was Datastream. All annual financials were gathered on December 31st of each year. Datastream provided all needed variables except acquisitions, which were retrieved from Zephyr. All transactions regarding acquisitions were gathered and then matched to the company based on ISIN. Because separate databases are used, there was the issue of currencies being different for certain variables and thus end-of-the-year currency exchange rates from XE.com are used to make sure all variables are in the same currency per company.
32 A.2: Sample Selection Bias Table
Because so many firms are omitted from my final sample, as mentioned in the Data Description, some descriptive statistics of the omitted and included firms are compared. This is to show any bias in the selection of samples. Table 5 presents these statistics below. It is shown that the standard deviation for the firm variables is larger for the unused firms, but they tend to be similar in median values.
Table 5: Descriptive Statistics of Used and Unused Sample
Mean Median St. Dev. Minimum Maximum
Used Sample N = 3559
Return on Assets 0.074 0.160 0.393 -0.734 0.443
Cash Ratio 0.563 0.127 1.538 0.000 11.715
Size 12.562 12.628 2.624 6.335 18.179
Working Capital Ratio 0.083 0.170 0.667 -9.577 6.781
Market/Book Ratio 2.862 1.564 4.745 0.001 36.628 Leverage 0.257 0.179 0.318 0.000 2.033 Unused Sample N = 220 Return on Assets -0.432 0.018 2.512 -20.000 0.642 Cash Ratio 0.698 0.067 2.825 0.000 19.333 Size 12.833 13.649 3.445 0.693 19.361
Working Capital Ratio -0.113 0.012 0.812 -5.914 0.994
Market/Book Ratio 3.409 2.005 4.809 0.002 52.492
Leverage 0.416 0.246 1.130 0.000 10.238
33 A.3: Pearson Correlation Matrix
Multicollinearity occurs when there is a high correlation between explanatory variables. These correlations make it difficult to note the marginal effect of an explanatory variable on the dependent variable, because it is not possible to keep all other variables constant. This can lead to biased results. To check for multicollinearity, a Pearson correlation coefficient matrix is estimated and the common rule of thumb is that no correlation should be more than 0.7 between explanatory variables. It can be seen that none of the explanatory variables are highly significantly correlated because the coefficients are all less than 0.7.
Table 6: Correlation Matrix
ROA Ebitda Cash/ Sales
Cash/
Assets RD CapEx Acq Size WC MB Lev
34 A.4:Unconditional OLS Equations
35 A.5: Unconditional Correlation of Error Terms
In Table 7 are the correlations of the error terms from the SUR when omitting different
exogenous variables. These are presented to show whether the correlation is also unconditional. Unconditional correlation mean that the correlation of the dependent variables’ error terms is rather constant when the right hand side of the equation is altered. The variables chosen for this paper that jointly determine cash and profitability include legal system dummy and a proxy for firm investment. The SUR is estimated three more times: once omitting the dummy and
interaction terms, once omitting the investment variables (R&D, CapEx, and acquisitions), and finally omitting both the legal system dummy and investment variables leaving only the control variables. It is shown that the correlation of error terms changes very little as the right hand side is changed. This gives evidence of a unconditional correlation between cash and profitability.
Table 7: Correlation of Error Terms
