Cash holdings, an important component in firm's balance sheets, are given much interest from corporations, investors, and analyst. The level of cash holdings and liquid assets hold by firm will affect the probability of corporate default and bankruptcy (Acharya, et al., 2011).
According to (Keynes, 1936), there are three main reasons to hold cash or liquid assets: Transaction purposes, precautionary reasons during emergency and speculative purposes such as investment. There are two main benefits from holding cash. First, sufficient cash holdings will reduce the frequency of withdrawal or liquidation on the cash and liquid assets to obligate current payment. Second, the excessive cash or liquid assets allows firm to grab good investment opportunities and finance its operating expenses when other sources of funding are not available or relatively very expensive to utilized (Opler, et al., 1999). The first benefit of holding cash mentioned is similar with transaction motive in Keynes theories, and the second advantage is referring to the precautionary motive. Advantages of holding more cash in corporations' balance sheet provide high liquidity level and avoid some cost when cash holdings is insufficient such as external finance, which is relatively during the existence of information asymmetry in corporation (Myers S. & Majluf, 1984). Hence, managers hold sufficient liquid assets become especially significant in recessions. Corporations with sufficient cash holdings able to survive during economy downturn and may avoid necessitate to top up funding through expensive and costly credit market, which the expenses on interest paid will reduce the profitability and gain of corporations.
However, holding too much excessive cash also involved cost. Holding liquid assets, which considered unproductive and generate lower or no return, implies opportunity cost to corporation. Firm have to give up some positive NPV investment activities to continue holding high level of cash. Large cash reserve can increase agency conflicts between managers and shareholders. Managers may spend excessive cash on value-decreasing project or use it on his own interest, which goes against shareholders' interest (Jensen, 1986). Cash can be viewed as ''Negative debt'' only in the absence of financial frictions or in constrained firms with low hedging needs (Acharya & Johnson, 2007). The disagreement is that significant components in corporations still remain unchanged even firm use cash or debt for investment expenditure. Therefore, if an optimal capital structure is existed and practical for a corporation, the optimal capital structure indicates an optimal amount of net debt (debt minus cash), instead of a optimal cash holdings level. As a result, there is no optimal amount of cash, because cash is simply negative debt. The pecking order and financing hierarchy model have the same opinion in viewing optimal cash holdings in corporations.
3.1.1 Keynes's theory
(Keynes, 1936) found that money demanded mainly due to three motives which are transaction, precautionary and speculative. Transaction and precautionary provide convenience and certainty for remain sufficient liquidity in corporation daily operation. Speculative motive focus on the utilize cash to generate money yield in capital and financial market. Demand for money is closely related to liquidity preference in corporation and individual. A important contribution in his money function theory as he combine money demand function with new and important component in finance literature (interest rate) into the existing money demand functions. In his theories, he demonstrated that there are two assets available in corporation's balance sheet, non-productive cash or less liquidity assets that with interest rate return, which usually refer to liquid assets and less liquid assets such as bonds. He conclude that cash holding is strongly depends on the cost or opportunity cost of holding cash and transaction cost involved in ordering new inventories. If the interest rate is high or the re-order cost is high, then cash holdings will be lesser coz it's more ideal to purchase inventories in bigger size and pay the bill instead of spending using external funding. In his paper, he mentioned that a reduction in tax will raise the interest rate, thus increase the velocity of the money spending.
3.1.2 Agency Cost Model
In the existence of agency costs of managerial discretion, managers might choose to hold more cash and use it on its own objectives at shareholder expense, simply because it is risk averse and more flexibility in cash management. Cash is like costless cash flow. Cash allows managers to make investments that the capital markets would not be keen to supply funding. At this point, cash is no longer a negative debt. As holding excess cash is an advantage for management, managers may hoard cash and wants to keep funds within the firm, therefore, the distribution of payouts to shareholders will be reduce or ignored. However, management must find ways to spend it to avoid argument from shareholders, and hence they might select low quality projects when high return projects are not accessible. Cash allows manager to utilize it on any type of investment or project, however, external funding may not available at any time and use on any risky expenditure. Manager can spend the cash for its self- interest investment. As cash provides easier funding, management can keep away from capital markets discipline and this raise the probability of adverse effect on firm value. The proportional increase in one dollar in cash may create value that less than one dollar in firm value.
To the degree that agency costs of managerial discretion are more serious for low market-to-book firms than for high market-to-book firms. (Stulz, 1990) state that managers value investment because they beneficial from increasing investment even when firm invests in negative net present value (NPV) projects which are overpaid in acquisitions. When cash flow is high, they prefer to invest in negative NPV projects rather than pay out cash to shareholders as dividend. Shareholders will not believe on managers when they explain the reason of the negative return project as the cause of insufficient corporate cash level. Therefore, shareholders will assume managers to hoard high excess cash as shareholders may not know all the information in management. Due to agency inconsistency between managers and shareholders, self-interested managers might hoard more cash to achieve their own interests at the expense of shareholders.
Jensen (1986) implies that self-interested managers have motivations to hold more cash in order to forefend the capital market discipline. The agency problem is occurred in corporate cash holdings as managers motive to maintain certain level of cash and use the assets in firm which under their control for his self-interest objectives, however, the actual owner of the firm (shareholders) wish management to maximize the shareholder's wealth by regularly payout or dividend (Jensen, 1986). Guney, Ozkan, & Ozkan (2006) study on cash holding behavior of firms from France, Germany, Japan, the UK and the US using data for 4,069 companies over the period 1996-2000. They investigate whether the nature of the relationship between cash holdings and leverage changes with legal protection of investors and ownership concentration and conclude ownership concentration has the opposite effect on cash holdings. They demonstrate ownership concentration have significant implications for possible agency problems. In their study, they mentioned that large shareholders might have motivations to rise up the funds level with power of majority group to consume corporate advantages at the expense of minority shareholders. Accumulate high cash holdings level is one of the action to achieve their objective. With large amount of cash holdings, large shareholders (controlling shareholders) are less likely will abandon the control power and share the efficiency profit with outside shareholders. Therefore, the explanation implies a positive relationship between ownership concentration and cash balances.
As a study of agency cost on controlling managers in corporation, Kalcheva & Lins (2007) establish an index to evaluate the level of managerial control and entrenchment by using managerial control rights data for over 5000 firms from 31 countries, which including firm-level agency cost proxies to analysis the net costs and benefits of corporate liquidity. They found controlling managers hoard high cash level and the level of cash holdings is higher when country-level external shareholder protection is weak, and it impact on lower firm value. On the other word, the agency problem is getting serious as the controlling manager able to spend the cash on self-interest project when the shareholder has limited power to control the management and cash holdings level. Their study shows that the higher level of cash holdings in firms with controlling families or managers is a symbol of management entrenchment. They found that investors will hold average cash at par in strong country-level governance. The finding for poorly governed firms with entrenched managers is tally with the in general existing U.S. and international cross-sectional evidence.
Another similar study conduct on controlling shareholders, Ozkan & Ozkan (2004) analyze the effect of managerial ownership structure of UK firms on their cash holdings level. They found evidence of a non-monotonic relationship between managerial ownership and cash holdings. They observe that cash holdings initially decrease and then increase as managerial ownership increases. They found that corporations with families as controlling shareholders are connected with more cash balance. They conclude that the high cash holdings level is unexplained by entrenched managers and family shareholders as a result of deficient external discipline and inefficient monitoring by institutional investors in the U.K. They show a motivation association effect at the low managerial ownership level, however, an entrenchment effect at the high managerial ownership level. They also illustrate that the existence of controlling family shareholders is related with a higher level of cash holdings, it serves as a technique to preserve family control.
The finding is consistent with result found in the study of Harford et al. (2008). They study on the relation of corporate governance and cash holdings in the U.S. using the antitakeover index constructed by Gompers, Ishii and Metrick (2003) and the entrenchment index assembled by Bebchuk, Cohen and Ferrell (2009). In their study, they document weakly controlled managers in the U.S. prefer to use up cash rapidly on capital expenditure and acquisitions rather than holding cash in corporate balance sheet. As connected to his previous relevant study, Harford (1990) suggest that it is reasonable for shareholders to be worry about managers' stewardship of large amount of internal funds, as proven in his research that cash-rich firms are more likely to construct acquisitions and their acquisitions are more likely to be value-decreasing. Therefore, the higher cash holdings in corporation may leads to a decrease in firm value.
Lau & Block (2012) investigate on the agency cost level on different type of organization, controlling founders and families, and their implications on firm value. By using a sample of S&P 500 firms from 1994-2003, they found that founder firms on average hold a significantly higher level of cash holdings than family than broadly held firms, family firms relatively not hoard high cash holdings compared to broadly held firms when family firms are run by family members. In their study, they conclude that the motivation of founder firms on hoarding high cash holdings level is not spend those cash for self-interest objective at the expense of minority shareholders. However, their finding that when founders involve in top management level (CEO or chairperson), the higher level of cash is explainable with a higher firm value. Thus, the existence of founders in management is actually help in moderate the agency cost of cash holdings. This study is serve as an additional evidence in the empirical evidence in the cash holding literature, which shows that the existence of families as controlling shareholders is connected with higher levels of cash holdings, which contribute to lower firm values (Kalcheva & Lins, 2007; Ozkan & Ozkan, 2004).
Ownership concentration is an indication of good corporate governance as it can mitigate the agency problems in the western countries. However, this theory is not always true, especially for firms in the East Asian countries (Hanazaki & Liu, 2007). They analyze on the family ownership structure in Indonesia, Korea, Malaysia, the Philippines, and Thailand that characterizes East Asian corporate governance. As their finding, they document that family ownership structure and poor protection of outside investors in weak corporate governance are the facts that activate the occurrence of crisis and result in serious impact on corporation. Relative to the firms in the Western countries, large or concentrated shareholdings in the firms of East Asian countries, are inversely represent for a an indication of poor corporate governance (Abdullah, 2006).
Abdullah (2006) observe on the effect of board independence, CEO duality and ownership structure on non-finance distress firms using a sample of distressed companies and a matched-pair sample of non-distressed companies listed on the Bursa Malaysia. This study using data that contain of 3 financial periods starting form 1999-2001. He found that board independence and CEO duality are not associated with financial distressed status. Management and non-executive directors' interests are responding negatively with financial distress. A negative relationship is also found for outside blockholders with financial distress. The evidence also supports the argument that ownership by non-executive directors and outside blockholders effectively increases their incentives to monitor management in ensuring their wealth in the firms is intact. Therefore, a diversified or relatively less concentrated shareholdings help in mitigate the agency cost in East Asian countries.
Dittmar & Mahrt-smith (2007) examine the influence of corporate governance on firm value. They include the theory of agency cost and examine the managerial entrenchment and shareholder controlling on both the value and the way of spending cash holdings. They found that governance has a significant impact on firm value through its impact on cash holdings in the U.S. Well-governed firms in the U.S able to generate higher value of cash holdings relatively to poor-governance firms. Their finding emphasize the substance of corporate governance in determining the level of cash holdings and how cash holdings have an effect on firm value, which is tally with the explanation of cash holdings in agency cost.
Harford, Mansi & Maxwell (2008) investigate the relationship among cash holdings, insider ownership and firm governance structure using multiple governance measures on U.S. data, and found that U.S. firms with poor governance have lower levels of cash holdings, and a positive relationship between insider ownership and cash holdings. They argue that their results show penetration dealing with country-level shareholder rights and firm-level agency conflict. Its limited constraints to blocking managers to holdings high cash level in weakly controlled managers working in countries with poor shareholder protection. In line with the same type of managers but in countries with stronger shareholder protection are powerless to hold more cash because their cash hoarding action will be very observable. They document that higher insider ownership not recommend unnecessary expenditure on low value investment. Managers hurriedly use the cash on any investments, which avoid the probability of being judge by shareholder. However, managers may put down the value of shareholder as the investment selected may not generate positive return.
3.1.3 Trade-off Theory
There are several theoretical models that can help to explain which firm characteristics influence cash holdings decisions, however, this study only select and explain three main models that contribute to the cash holdings literature in detail to concentrate the focus of this study. It contain of agency model, trade off theory and pecking off model. Trade-off theory is one of the important models in explaining the firm characteristics and how the firm estimates the optimal cash holdings level in corporations. The trade-off model postulates that firms identify their optimal level of cash holdings by weighting the marginal costs and marginal benefits of holding cash.
Opler, Pinkowitz, Stulz, & Williamson (1999) demonstrate empirical evidence to support the trade-off model on a study conducted using U.S. data. They found some firm's characteristics will leads to higher cash holdings such as smaller firm size, higher level capital expenditure, higher growth opportunities, higher volatility of cash flows and lower net working capital. These firm characteristics are estimated based on the marginal costs and benefits of holding cash which consistent with the theory of trade-off model. Additionally, they show little proof to support the agency theory of cash holding. Ferreira & Vilela (2004) conduct the similar study on 12 countries from the European Union and greatly support the empirical findings in Opler et al. (1999). Furthermore, they include bank debt as a new variable in determine the cash holdings level and show a negative relationship between bank debt and cash holdings, which explain a bank debt (accessibility to external funding) reduce the necessitate to hold more cash for precautionary reasons. The benefits of hoard sufficient corporate cash holdings are the as below:
First, cash holding is very significant in financing the growth opportunities of firm and support the company growth. Cash holdings mitigate the likelihood of financial distress as it serves as a safety reserve (Levasseur, 1979) to overcome any unexpected losses or external fund raising constrains.
Second, since firm operate in an imperfect market, they may face difficulties to access the capital markets for external funding. Cash holdings allow the firm maintain and optimal investment policy even when financial constraints are existed. Or else, firm will be force to forgo investment projects with positive net present value (NPV) when they meet with financial constraints.
Third, cash holding allows firms to avoid the costs of raising external funds or liquidating existing assets which involve liquidation cost and probably facing a loss as liquid at lower market price. It serves as a buffer between the firm fund resources and the utilization of funds.
The traditional marginal cost of cash holdings opportunity cost of the capital due to the low return on liquid asset which is referred to as cost-of-carry (Dittmar, Mahrt-Smith, & Servaes, 2003), relatively to other alternative investment which contain high risk and low liquidity level. Below is a rough description of the firm characteristics under the theory of trade-off model and the firm characteristics applicable in explain the firm cash holdings decisions.
Investment opportunity set
Cash holdings allow firms to avoid expensive external funds and hence to undertake their money-making investment projects. Higher cost impact on the firm with higher investment opportunities during a shortage of corporate cash as the expected losses caused of giving up or abandon the valuable investment opportunities is higher. As a result, investment opportunity and cash holdings should have a positive relationship. Firms with better investment opportunities have larger financial distress costs because the high return of these investments will disappear when bankruptcy occurred. Therefore, firms with better investment opportunities will maintain higher levels of cash to stay away from financial distress under the view of trade off model.
Liquid asset substitutes
Liquid assets other than cash can be liquidated in short time when firms experience a cash shortage; therefore, they serve as substitution for cash holdings. Liquid assets other than cash can be converted easily into cash and represent a complete and convenience replacement for cash holdings. Assets that can be readily exchanges for cash, while involving lower transaction costs, should have a lower return to reflect their greater liquidity, but its return is still better relative to cash. Thus, firms will prefer to hold the liquid assets substitutions that with higher return than cash and liquid it at lower liquidation fees when cash is needed. Thus, firms with more liquid asset substitutes are predicted to hold less corporate cash. Therefore, cash holdings are negatively related with these liquid assets substitutes.
Leverage
It is in general show that high leverage will raise the chances of insolvency as a result of the pressure place on the firms' treasury management policy. Less leverage firms can relatively accumulate larger amount of cash without being under monitor and observation of capital market. To mitigate the probability of trap in financial distress, firms with higher leverage are likely to hold higher cash level as reserves. Additionally, more capable firms able to obtain external funding in capital market which provide debt or equity, serve as cash substitution to finance firm's investment opportunities. Therefore, it's expected the firm with high ability and easier to access to capital market (high leverage) will have low necessitate hoarding more cash. Hence, the expected relationship between cash holdings and leverage is not clearly determined under the trade-off models (Ferreira & Vilela, 2004; Saddour, 2006).
Cash flow and cash flow uncertainty
Since the corporate cash flow serve as a ready stand-by fund and source of liquidity to finance firms' investment (Kim, Mauer, & Sherman, 1998). Thus it can be seen as a cash substitute and it's predicted a negative correlated relationship between cash flow and cash holdings. However, the cash flow uncertainty reacts differently than corporate cash flow. Firms with more volatile cash flow experience liquidity constraints and cash shortage will leads the firm to forgo some positive NPV investment projects. High volatility of cash flows will encourage firm to hold more cash as the higher chances in facing cash shortages due to unanticipated cash flow deterioration. Thus, cash flow uncertainty is expected positively related with cash holdings.
3.1.4 Pecking Order Theory
The pecking order theory beginning by (Myers, 1984) on the first paper study on how firms choose the debt, equity or hybrid securities they issue and make decision on capital structures. He states that firms will prefer internal finance with retained earnings. If external finance is required, they will start with safe debt and risky debt, then possibly hybrid securities such as convertible bonds, then maybe equity as a last resort. The intention of this financing hierarchy is to diminish asymmetric information costs and avoid the extra financing costs. This theory proposes that firms do not have well-defined target debt-to-value ratio, and cash is serve as a buffer between accumulative earnings and investment requirements. Thus, when existing operational cash flows are sufficient to finance new investments, firms settle the corporate debt and hoarding cash.
Another similar study conducted by Myers S. & Majluf (1984), an extension of pecking order theory to the explanation of the determinants of cash holdings, leads to the conclusion that there is no optimal cash level. It is used as a buffer between retained earnings and investment needs. The cash level is the outcome of the financing and investment decision. Under this theory, issuing new equities is very expensive for firms because of information asymmetric. Management is expected to have more information and understand more in estimate the firm's value than potential investors. Investors interpret the firm's actions rationally. The model shows that firms may not choose to issue stock, and for that reason the firms may forgo valuable investment opportunities. The primary emphasis of the pecking order model is on the asymmetric information costs connected with increase external funding and the main goal of financial strategy for most firms is to maintain liquid and flexibility of the corporate financial. (Opler, et al., 1999).
According to this view, changes in internally generates cash flows are the main reason for changes in cash holdings. But it is big different on the firm decision on capital structures. When retained earnings are not sufficient to finance existing investment, firms use the accumulated cash holdings and, if needed, issue debt (Ferreira & Vilela, 2004; Opler, et al., 1999; Saddour, 2006). Trade off model and pecking order theory view certain firms' characteristics differently. The leverage is unclear to determined, real size and cash flow is negatively related to cash holdings under trade off theory. In pecking off theory, the relationship between the leverage and cash holdings is negative related, real size and cash flow is positively correlated to cash holdings level.
3.2 Determinants of Cash Holdings
The existing studies conduct on cash holdings determinants is combining and including many determinants of cash holdings in a study, therefore, the literature for the cash holdings determinants is demonstrated under the same section, as these determinants are correlated to each other such. Therefore, it provides a clear picture on the literatures and easier to understand the impact of the determinants on cash holdings.
Liquid assets substitutes
Liquid or current assets can easily be conveyed into cash are consider the complete substitutions for cash holdings. For example, current assets such as inventory can be a substitute for cash holdings. Firms are allowed to transform it into cash through liquidation process, somehow, it involve certain level of liquidation fees. Opler, et al., (1999) measure the liquid assets substitutes using net working capital, minus cash and found that a negative relationship between the liquid assets substitutes level and cash holdings. Therefore, firms will hold less cash balances when there are sufficient liquid assets substitutes act as cash substitutions. Guney, Ozkan & Ozkan (2006) forecast that the liquidity level is negatively related to firm's cash holdings which is consistent with the findings in (Opler, et al., 1999) as they employ the same ratio in the said study as a proxy for liquid asset substitutes. Ferreira & Vilela (2004) using the net working capital to assets ratio as a proxy for liquid asset substitutes as it's a perfect substitutions to replace the role of cash holdings in balance sheet. They measure net working capital to assets ratio as new current assets minus total cash and equivalent divided by total assets minus total cash and equivalent.
Other than liquid assets substitutes, net working capital can hence be serving as a cash substitute both in public and private firms (Opler, et al., 1999). They net working capital is calculated as net current assets minus cash and their study concludes a negative relationship between net working capital and cash holdings. Therefore, the private firms with a higher net working capital are expected to hold lower cash balances.. In fact, the net working capital is serving similar function as the role of liquid assets substitutes in influencing the determinants of cash holdings. Other than the internal cash substitutions, cash holdings also determined by the external cash substitutions which able to access in financial and capital market such as bank debt, FDI inflow, securities and equity.
External Funding
Bank debt plays a important role in determining the amount of cash holdings in private firms, as they are not allow to issuing equity in stock market to raise fund and finance their investments. As private firm is not a listed company, bank debts become their main sources of the external funding. In fact, in order to observe small private borrowers, banks tend to collect non-public information to decrease the high information asymmetry that characterizes them (Fama, 1985). Pinkowitz & Williamson R. (2001) conduct a comparative study on the effect of bank power on cash holdings level using industrial firms from the United States, Germany and Japan and show that Japanese firms are holding relatively more cash than U.S. or Germen firms. They demonstrate that Japanese cash balances are influenced by the monopoly power in banking industry. Based on Japanese data, they state that the strong Japanese banks persuade firms to hold large cash balances. Therefore, the bank debt is positive related to cash holdings in this special circumstance. The results indicate that the institutional environment is associated in determining the level of cash holdings.
Dissimilar with the findings in Pinkowitz and Williamson (2001), Bigelli & Sanchez-Vidal (2012) document both bank debt and net working capital represent good cash-substitutes. Other than cash substitutes, they also include alternative common cash holdings determinants in their study. They conduct study on a large sample of Italian private firm and show that cash holdings are significantly related with smaller size, higher risk and lower effective tax rates, thus the findings is tally with trade-off model. Their result also consistent with financing hierarchy theory, firms with longer cash conversion cycles and lower financing deficits will hold higher cash levels. Furthermore, they found that cash-rich companies are more capable in generate profit, make payout for shareholders and invest more in future project especially in medium-term investment. Their finding on the bank debt and cash holdings relationship is consistent with Ferreira & Vilela (2004).
Ferreira & Vilela (2004) use bank borrowings to total debt as proxy to bank debt, and debt maturity measures using debt repayable in more than one year to total debt. The reason on negative relationship between Bank debt and cash holdings can be explained by the close relationship with banks permit the firm to hold less cash for precautionary reasons (Ferreira & Vilela, 2004). Furthermore, the negative relation between cash and bank debt supports the view bank are in better position to access the firm's credit quality and to monitor and control the firm financial policies, cutting down the asymmetry and agency problems usually asoociated to other kind sof debt. Their finding is totally disagreeing on the result in Pinkowitz and Williamson (2001).
The other typical substitutes of cash are financial facilities in capital market. Chang & Noorbakhsh (2006) show that foreign Direct Investment (FDI) inflows which actively incorporate in existing capital market, able to serves as cash substitutes for corporate cash holdings. They examine on firms in G-7 countries and found that FDI inflows reveal different effects on international corporate cash holdings. FDI react as substitutes for cash holdings in the previous group of countries but turn out to be complements for cash holdings in the firm operate in latest group of countries. Development in capital markets has a negative impact on cash levels, which conversely relative to the agency theory (Ferreira & Vilela, 2004).
Firm Size
The firm size also play important role in determine the corporate cash holdings level. Firms in larger size is recognized been more successful than smaller firms, and hence should have more cash, after controlling for investment (Opler, et al., 1999). Their finding is consistent with Ferreira & Vilela (2004). They employ the natural logarithm of total assets in constant year 2000 Euros as a proxy for the real size of firms. Larger firms tend to have larger shareholder spreading, which raise superior managerial discretion. Moreover, larger companies are not likely to be 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 (Ferreira & Vilela, 2004).
However, some literature show an inversely result on the effect of firm size on cash holdings. Smaller firms tend to hold larger cash balances relative to their total assets than those firm in larger size (Chang & A., 2006). Smaller firms are likely to hold more cash can be explained by their lower accessibility to capital and therefore internal cash reserve is significant in overcome any unexpected uncertainty on cash flow.
Cash holdings level will be determined by the risk level that associated with the firms' operation and business exploration. Opler at al. (1999) document that riskier companies are likely to hold higher cash reserves than firms operate in normal industry. Their finding shows little support to proof that cash holdings lead to greater short-run effect on capital expenditure or acquisitions spending. They also conclude that the existence of operating losses is the main reason why firms adjust and make large changes in cash holdings. Another study in (Guney, Ozkan, & Ozkan, 2006) natural logarithm of total sales (1996 as constant prices) as a proxy for the size of firms size, to the degree that size is an opposite proxy for the level of informational asymmetry between insiders and outside investors, a negative relation should be expected between firm size and cash holdings.
Investment opportunities
Besides, Opler at al. (1999) include the other potential determinants of cash holdings in their study and found that investment opportunities is significant in determine the cash holdings. Firms with large amount of profitable investment opportunities will face greater losses if firms have to forgo the better projects due to cash shortage. Firms with better projection for profitable investment opportunities will then be likely to hoard more cash and high levels of liquid assets (Opler, et al., 1999). The result is tally with (Ferreira & Vilela, 2004) when they examine the determinants of corporate cash holdings in EMU countries. Their finding shows that cash holdings are positively connected to the investment opportunity set and cash flows, and negatively related to asset's liquidity, leverage and size.
The investment opportunity is showing a similar outcome with other determinants of cash holdings which is growth opportunities, both of them are expected to be positively related to cash holdings. Therefore, some of the literatures measure the investment opportunity and growth opportunity using the same ratio. However, the ways to define the ratio is very likely depends on their own justifications. (Guney, et al., 2006) using the market-to-book ratio as a proxy for growth opportunities of firms, defined as the ratio of book value of total assets minus the book value of equity plus the market value of equity to book value of assets. Ferreira & Vilela (2004) employ the same ratio as a proxy for firms' investment opportunities. They estimate the market value of the firm's assets as the book value of assets minus the book value of equity plus the market value of equity. The market-to-book ratio is given by the market value of assets divided by the book value of assets.
However, the relationship between investment opportunities and cash holdings is dissimilar under different cash holding theory. From a view of free cash flow theory, managers of firms with poor investment opportunities are expected to hold more cash to ensure the availability of funds to invest in growth projects, even if the NPV of these projects is negative. This will destroys the value of shareholder and leads to a low market-to-book ratio if the firm largely invests in unprofitable investment and projects. Hence, using the market-to-book ratio as a proxy, it is likely that the relation between investment opportunities is negatively related with cash holdings.
Leverage
Guney, Ozkan, & Ozkan (2006) examine cash holding behavior of firms, including firm specific characteristics and country-specific information for 4,069 firms data set established from France, Germany, Japan, the UK and the US starting form year 1996-2000. In their study, they focus on comprehensive analysis of the effect of leverage on cash holdings. They are using the ratio of total debt to total assets as a proxy for leverage level which is the same applied in the study of (Opler, et al., 1999). This study is dissimilar with the past studies which conclude a positive relationship between leverage and cash holdings as firms are likely to hold more cash reserves for precautionary motive as they are with high leverage. Their study comment that the leverage should be negatively related to cash holdings due to the leverage levels of firms serves as a proxy for their ability to issue debt.
Ferreira & Vilela (2004) and Bigelli & Sanchez-Vidal (2012) estimate the leverage of a firm using the ratio of total debt divided by total assets less cash and equivalents, which applied in (Opler, et al., 1999). They document that low leverage firms are less exposed to capital market and external funding, therefore, they are less monitoring by shareholder and capital market. However, the less monitoring may leads to higher managerial agency dispersion, thus, the firms will choose to hold more cash for high flexibility and easy financial management. In their finding, they conclude that the relationship between the leverage and cash holdings should be negative.
According to pecking order theory, debt level will rise as fund required for investment is more than the accumulative cash balance and decreases when investment opportunities is lesser and cash holdings able to fulfill the funding needs. As a result, corporate cash balance accumulates according to the level of investment. As investment more than cash balance, then firm unable to accumulate cash and firm will collect more cash holdings while investment amount is less than the cash balance. This relationship between cash holdings, debt and investments propose that there is a negative relation between leverage and cash holdings.
Cash Flow
(Kim, et al., 1998) state that cash flow appears as an existing liquid asset which stands by for investments, short term debt and obligations. Firms with higher cash flows will experience lower risk of forgo good investment opportunities and go-through financial distress. Therefore, firms with higher cash flow level able to hoard less cash holdings, and it conclude a negative relationship between cash flow and cash holdings, which is consistent with the tradeoff argument.
However, most of the existing literature is supporting the view of pecking order theory on the relationship between cash flow and cash holdings. Guney, Ozkan, & Ozkan (2006) measure cash flows as the ratio of pretax profit plus depreciation to total assets. In addition, to the degree that cash flows are a proxy for growth options the relationship between cash flow and cash holdings should be positive. It's tally with the analysis in (Myers S. & Majluf, 1984), it is document that in the existence of asymmetric information and signaling problems connecting with external funding, firms will prefer to utilized internal funds for investment, instead of external funds which relatively more costly. This shows cash flow positively related to cash holdings. (Opler, et al., 1999) measure the total of earnings before interest and taxes (before depreciation and amortization) less interest, taxes and common dividends as the proxy for cash flow, and use cash flow over total assets in determine the cash holding level. In their finding, they conclude that the cash flow is significant and positively related to cash holdings, and consistent with static tradeoff theory.
Cash flow Volatility or Uncertainty
Firms with more unpredictable cash flows are likely to hold more cash in an effort to moderate the estimated costs of liquidity constraints. Cash shortage will leads to a cost when firms have to look for external fund to finance the investment or otherwise, to forgo the expected profit from valuable investment opportunities. However, firms with high cash holdings are not guarantee to invest in a positive return projects. For example, (Minton & Schrand, 1999) conclude a negative relation between cash flow volatility and investments, which propose that firms with more volatile cash flows tend to experience falling in internal cash flow and diving up good investment opportunities. Guney, Ozkan, & Ozkan (2006) measure the cash flow volatility using the standard deviation of cash flows divided by average total assets over the five year period from 1996 to 2000, which consistent with the one that has been adopted in the cash literature (Kim et al., 1998; Minton and Schrand, 1999; and Ozkan and Ozkan, 2004) among other alternative definitions of cash flow volatility. Their results remain unchanged and consistent with the past studies, although with alternative definitions in the ratio. For example, the standard deviation of the first difference in cash flows estimated using average book value of the assets.
(Opler, et al., 1999) study on the full 1994 sample include all firms in Compustat and measure cash flow riskiness using standard deviation of industry cash flow for the past 20 years, which also named as industry sigma in their study. They conclude that the firm volatility has a strong positive effect on cash holdings. (Ferreira & Vilela, 2004) measure cash flow uncertainty using the standard deviation of industry cash flow calculated using procedure recommended in Opler at al. (1999), their cash ratio standard deviation is calculated based on the 14 years of the sample, then take the average across the Datastream industry classification, excluding the maximum and minimum observations. However, they fail to conclude a significant relationship between cash flow volatility and cash holdings for EMU countries.
Dividend Payment
(Bigelli & Sanchez-Vidal, 2012) study on a sample of Italian private firms and document that more dividend payments are connected with more cash holdings. Private firms which usually incurring in financially constrained or high leverage level may facing difficulties in raising more debt when they need addition funding, as a result, they may raise the accumulative cash balances by reduce or cut off the dividend payments. In their paper, they use a variable set equal to one if the company paid a dividend and equal to zero otherwise, as proxy for dividend dummy, which applied in (Opler, et al., 1999) and widely follow by other studies in finance literature. They predict a the private firms react in an opposite one and explain that dividends payment in private firms should be associated with an extra cash balance that generated form cash flows and cash shortage in private firms will leads to lower dividend or no dividend. Therefore, the relationship between dividend payment and cash holdings in private firms should be positive, private firms that pay dividends have higher cash balances.
(Gogineni, Linn, & Yadav, 2012) study on a sample of more than 280,000 U.K. private firms from the 1994-2010 period. They using the same dividend dummy and conclude a positive and significant relationship between dividend payment dummy and subsidiary dummy show that private firms that pay dividends hold more cash, which consistent with the finding in (Bigelli & Sanchez-Vidal, 2012). In the past literature, the studies conduct on US corporations show that firms that pay dividends are likely to hold less cash balances (Harford, et al., 2008; Opler, et al., 1999). Even they employ the same way that proxy for dividend that applied in Opler, et al. (1999), their findings on the relationship between dividend payment and cash holdings is dissimilar. Therefore, it's expected the effect of dividend payment on cash holdings is very much depend on the firm structure, either public or private firms, and the selected countries in study sample (Opler, et al., 1999).
In fact, public firms seldom change their dividends subjecting to the changes in their performance while dividend payments in private firms are likely to be more sensitive connected to their operating performance (Brav, 2009). Ferreira & Vilela (2004) apply the same dividend dummy estimation on their study on EMU countries and find a consistent result in US corporations. They conclude a firm that pays regular dividends able to raise funds by lowers their dividend payments, which is not applicable to a firm that does not pay dividends and has to use the capital markets to raise funds. Hence, they predict a negative relationship between the dividend payment and cash holdings. They explain that firms that pay dividends hold less cash than firms that do not pay dividends, as they able to obtain the funding by simply reduce the dividend payment.
Length of the cash conversion cycle
Length of cash conversion cycle will indicate the firm's capability to generate cash from current operations and usually a shorter length able to generate higher the cash flow's frequency. It is significant in estimate the relationship between length of cash conversion cycle and cash holdings due to the cash conversion cycle is important fact in determine the working capital needed for a manufacturing industry to finance and run their daily operations. A shortage of cash in fulfill the days-to-days expenses may cause damage on the firms' reputation and performance. As recommended in (Opler, et al., 1999), firms with shorter cash conversion cycle are more likely to have a lower cash balances. Bigelli & Sanchez-Vidal (2012) study on a wide sample of Italian private firms and expect the finding in Opler et al. (1999) apply on both for public and private firms. They estimate the length of the cash conversion cycle (in days) is taken from the inventory (raw material, work-in-progress and finished goods) conversion period plus the receivable collection period minus the payment period for the accounts payable, as in (Kim, et al., 1998) and document that private firms with shorter cash conversion cycles show signs of lower cash balances. Therefore, their study provides evidence that the relationship between lengths of cash conversion cycle is positive and the finding will be the same for public and private firms.
3.3 Firm Performance and Corporate Cash Holdings
Most of the finance literature study on cash holdings and firms' performances on Japan corporations, focusing on the economy bubble and banking deregulations in the past few decades. Shinada Naoki, (2012) uses panel data from Japanese listed firms during 1980-2010 to examine the determinants of firms' cash holdings and investigate the relation among cash holdings, corporate performance and values. They use ROA (current profit/ total assets) and PBR (market capital/ total assets) to indicating corporate performance and relative market values. Their study document that an increased cash holdings in corporation cause by the trend of higher cash flow volatility since the 1990s and in particular in the 2000s, which mainly contributed by the constant accessibility of low-cost funding. They conclude that a large amount of investment opportunities will lead to positive relationship between cash holdings and firms' returns on assets and values, especially external investors highly value the Japan market in 2008, and however, this effect has been diminished in latest few years. Therefore, they summarized that conservative cash holdings could enhance the market values of the firm, but, the enhancement only sustain for short term. A very much conservative liquidity management policy would deteriorate firms' profitability on assets under a sudden deterioration in the economy.
It's common that finance literature to connecting firm's performance and firm's value together, as the performance of the firm determine the profitability and capability of firm in generate good return and attractive gains. Thus, the firm with good performance is associated with higher firm value, which estimated by the internal and external investors. (Kalcheva & Lins, 2006) study on the net costs and benefits of cash holdings by using managerial control rights data for over 5000 firms from 31 countries. They use year-before to year-end sales growth as a proxy for current and future performance. They document that when external country-level shareholder protection is weak, controlling managers tend to hold more cash and therefore, it leads to a lower firm value as investors may assume the firm's performance is getting worse sue to higher agency conflict. However, they also find that firm values are higher when controlling managers pay dividends even that external shareholder protection is weak. In their finding, they show the cash holdings and the hording cash action from controlling managers is not related to firm value when external shareholder protection is strong, which consistent with generally existing U.S. and international evidence.
Mikkelson and Partch (2003) test whether a conservative financial policies are more beneficiate managers' interests instead of the interests of stockholders, they examine the operating performance and other firm characteristics hoarding more than 25% of their assets in cash and cash equivalents for more continuously five years, which considered as cash rich firms in this study. They find that persistent extreme cash holdings do not lead to poor performance and do not represent conflicts of interest between managers and shareholders, evidence consistent with cash reserves enhancing firm value. They use the ratios of operating income to operating assets as the proxy for firm operation performance. Operating income is measured before interest, taxes, depreciation, and extraordinary items. They find that agency costs do not explain operating performance differences among high cash firms. Operating performance of high cash firms is comparable to or greater than the performance of firms with the similar size and industry. High cash holdings are supportive for greater investment, particularly R&D expenditures, and by greater growth in assets. They conclude that with persistently hold large cash reserves, which encourage more investment, do not hinder corporate performance.
Harford, Mansi, & Maxwell (2008) document a negative relationship between excessive cash holdings and firms' performance. In his previous study on the cash holdings conclude that firms with large cash balance will be likely to execute underperformance acquisitions (Harford, 1999). They using measurement of profitability to estimate the firm's performance, firm is earning a profit or positive profitability ratio exhibit a good and performing firm and otherwise. They examine the relation between the management of cash holdings and corporate governance and find that firms with weaker corporate governance have smaller cash reserves. Managers of firm with weaker governance are spending the cash balances more rapidly on acquisitions than the managers of firms with stronger governance. Furthermore, those investments in acquisitions, R&D, and capital expenditures by the firms with the weaken governance reduce firm value by destroy their firm profitability and hence impact on firms' stocks price.
Anagnostopoulou (2012) examine on the determinants and impact of cash holdings on future operating performance for listed and unlisted firms covers the period 2001-2009. He argues that determinants of cash holding should be different for public and private firms, which operate at particular leverage, corporate governance and relative agency frictions. He states that the cash holdings level in private firms are lower than public firms, which is not tally with finance literature that mentioned private firm with lesser external funding sources will hold more cash for precautionary motive. They use ROE (return on Equity or Net Income/Positive Shareholders' Equity) as the proxy for firm operating performance. The use of ROE as a proxy for operating performance is explainable by it focuses profitability and investment into a specific measurement, which exclude the total cash in this ratio. His study provides evidence on the importance of firm listing status in affecting cash holdings, a significant explanation on these lower ratios in private and public firms caused by differences in leverage, capital expenditures, internal cash flows generation, and corporate governance. The study show that high cash reserves are not an important factor in determine the future performance for public firms, their result is almost similar with the finding in Mikkelson and Partch (2003) for large cash holders, but they positively influence the future profitability of private firms as hoarding high levels of current cash could be an signal to reflect the development status of the firm is in an expansion stage.
However, there are some studies conclude an opposite direction with the findings in (Mikkelson & Partch, 2003) that show persistent high cash holdings will not hinder firms' performance. Pan (2006) examine whether a high level of corporate cash holdings will depreciate firm operation performance during a bubble economy in Japan. He document that the reaction of Japanese firms toward the level of cash holding during the late 1980s and early 1990s, either maintain a high or low cash holdings level. He defines operating performance as ordinary incomes over operating assets, the operating assets is the total assets minus cash and marketable securities. He provides evidence on the relations between cash holdings and the operating performance. His findings demonstrate a dissimilar result relatively to (Mikkelson & Partch, 2003) that high excessive cash hinder the operating performance of Japanese firms with persistent large cash holdings during a bubble economy, while a persistent low cash holdings will assist in improve the operating performance of Japanese firms.
A study investigates the determinants and consequences of the corporate cash holdings by using firm-level data of 4,515 firms in Canada, France, Germany, Great-Britain and the U.S. in the period starting from 1989-2002 (Couderc, 2005). He shows that cash balances levels and the future performance of firms is most likely jointly determined by using bivariate probit model. He estimates the firm performance by comparing it with the median firm performance. In his study, a good performance firm achieve better profit than the median firm, on the contrary, a bad performance firm is perform its profitability rate under the median profitability rate.. He concludes excessive cash holdings will lead to poor firm performances. If the performance of firms with excessive cash holdings is above average, firm performance is in consistent with the free cash flow hypothesis. On the other hand, this study document the association between high corporate cash holdings and firms' bad performance which supporting the managerial opportunism thesis, according to (Jensen, 1986). As a result in this study, a subsequent cash level in the firms' balance sheet is perhaps a sign for the existence of entrenched managers.
3.4 Implication of Cash Holding Decision on Firm Performance
The decision on cash holdings policy will affected the risk level that the corporations experienced, especially the credit risk and liquidity risk, thus directly impact on the firms' performance and market value. In general, the corporation with higher cash holdings should be safer and face lower credit risk. However, Acharya, Davydenko, & Strebulaev (2011) recommend the optimal cash reserves is actually significant and positively related to the risk spread and their findings show stronger evidence toward lower credit ratings. They develop a regression model of the firm's endogenous cash policy in the existence of expensive default and limited access to external finance. They document lower credit ratings company which holding more cash is riskier than other higher rating firms, as they required higher cash level for precautionary motive. On the other hand, spreads are negatively associated to the cash holdings determinant which is independent of credit risk factors. Therefore, they conclude that corporate liquidity is positively responding to both credit spreads and the long-term default probability. Thus, higher liquidity results in higher credit risk. In their findings, they suggest that firms tend to maintain a high cash holdings policy when the precautionary motive become their main concern in cash management. Firms with higher requirement for precautionary savings are expected to tolerate with higher risk than others and face a higher probability of default.
The Cash holdings decision is generally determined by corporations' manager based on their cash holdings policy. (Beuselinck, Deloof, & Vanstraelen, 2012) examine they type of cash policies of multinational corporations by using a sample of European MNCs and their subsidiaries starting from year 1998-2004. They estimate the cash holdings by using estimate it as the natural log of cash and cash equivalents over net assets, which is calculated as total assets less cash and cash equivalents. They find that most of the foreign subsidiaries practice with high cash holding policy than domestic subsidiaries, as a result of a higher informational advantage of the foreign subsidiary from headquarter as they operate in a different environment rather than the home country. They document that geographical distance from headquarters do not matter on the cash holdings policy held by subsidiaries. In their study, a subsidiary that operates in the same industry as their parent is likely to hold more cash reserves since the horizontal subsidiary drive business more independently from headquarters as subsidiary own superior knowledge and lower interdependence from headquarters. Better law enforcement and lower corruption will encourage subsidiary to hoard more cash balance and practice with high cash policy, which explain by the lower risk of exposed by the subsidiary management. They also investigate on the availability of external finance in the subsidiary country and find that easy access to external funding due to higher investor protection has decreased the level of cash holdings in subsidiary.
Mura & Marchica (2008) examine the influence of the different cash holdings policies on the corporation investment decision, in two groups of firms, with different liquidity position. They apply GMM and cross-sections average (CSA) to include the two issues that overleap in the previous literature: endogeneity along with the variables containing in the cash model and the development of the adjustment speed over time. They conclude investment opportunities can be separate into present and future investment and sufficient corporate cash holding may protect the capability to invest in presence potential investment without affected by market frictions. In their study, they show that firms with persistently holding low cash policy will less invest in fixed capital investment, they usually will look for irregular external funding to finance their needs for future investment and acquisitions. Therefore, they conclude that cash policy has important impact on the pattern of capital expenditures. Their study document that cash-rich firms are less affected by cash flow sensitivity, furthermore, they also less exposed to friction market and probability on overinvestment issues. As advantage of holdings high cash policy, firms will have excessive internal funds which permit firms to expand their business by invest more in positive NPV investment, execute the intended acquisitions and distribute more dividend payment, thus, it believe will generate a positive impact on firm value and better firm's performance.
3.5 Macroeconomics Uncertainties and Corporate Cash Holdings
Macroeconomic conditions play an important role in affect corporate cash holdings and the liquidity position in corporations, however, only several literatures provide relevant evidence in connecting cash holdings and macroeconomics factors. Kim et al. (1998) investigate the existence of expensive external financing on the decision of firms on holding liquid assets by using U.S. industrial firms' data. In general, the estimated target cash holding level is measure based on tradeoff theory which considers the cost and benefit of holding cash reserve and utilized external finance when sufficient internal fund is not available. In their study, they document that firms will hoard more cash balances when they expect the macroeconomics variables is not preferred, to avoid any possibility to forgo good investment opportunities. Their empirical study finds that the large set of U.S. industrial firms provides strong evidence to sustain their prediction on the optimal investment and corporate liquidity position. As a result of this study, external finance cost increases, predicted future cash flows volatility, and the return on future investment opportunities will lead to higher corporate cash holdings, in response to expected changes in macroeconomic variables.
Similar findings with (Kim, et al., 1998; Natke, 2001) conclude firms will hoard higher cash holdings due to uncertainty of high inflationary economy. However, the result restricted to local firm instead of multinational firms' local subsidiaries in his study, as these firms might obtain financial support from their headquarters. He examines the effect of economy uncertainty on cash holdings on two groups of sample, local firms and multinational firm's local subsidiaries, using the data for Brazil manufacturing firms from 1973 to 1976 characterized by substantial inflation. This is inconsistent with the other study that investigates on the cash holdings level by domestic and foreign subsidiaries (Beuselinck, et al., 2012), They conclude that foreign subsidiaries may hoard higher cash reserves due to independent from headquarter and gaining superior knowledge than local subsidiaries. He finds that interest rates have an effect on corporate cash holdings as the economies of scale existed. He includes the inflation measurement and the price level into the cross-sectional testing of liquid asset demand and concludes that economies of scale exist stably over time. As the finding in this study, corporate liquidity position is significant related to interest rates and flexible adjusted by the changes in interests rates. Besides, inflation provide instable result in the relation with cash holdings, but most of the outcome show that firms become mote conserve on cash holdings when inflation rates raise, which recommend a more cautious cash flow payment.
Talavera, Ozkan, Caglayan, & Baum (2004) examine the impact of macroeconomic shocks on non-financial firms' cash holdings behavior in the period of 1970 - 2000. They using an augmented cash buffer-stock model and expect to find evidence on their prediction on that a rise in macroeconomic uncertainty will lead to narrower cross-sectional distribution of firms' cash to asset ratios. They find that the managers will allocate the cash holdings as they expect a great fluctuations in macroeconomic. They demonstrate that macroeconomic volatility would have an effect on managers' determination of the appropriate level of cash holdings. Hence, a firm will behave more homogeneously during high macroeconomic uncertainty. Furthermore, large firms, durable-goods firms, high growth firms and firms incurring in financial constraints adjusting their cash holdings more aggressive and largely in response to macroeconomic volatility for precautionary motive. Thus, their findings show that a firm's cash-holding behavior is closely associated with financial constraints and firm-specific characteristics.
Chen & Mahajan (2010) study the e
