STORY holdings that are sensitive to cash flow



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for holding cash

Myriad of literatures
have debated the matter of contributing factors that affect cash holding
policy. These empirical literatures put several explanations in the incentives
of firm to hold cash. Three main reasons were recognized as precautionary
purpose, transaction cost and the wealth of investor.

The first,
precautionary purpose is the initial reason for the company to hold more cash. Opler
et al. (1999) suggests that managers tend to hold cash as a precautionary
measure. In order to protect themselves against adverse shocks, firms hold cash
to have easily accessible capital in times when raising capital in the market
is expensive. Opler, Pinkowitz, Stulz, and Williamson (1999) find that firms
with riskier cash flows hold more cash and thereby provide evidence for this
motive. Their findings also support the hypothesis that firms with better
investment opportunities will hold more cash, due to higher opportunity cost in
the event of financial distress. Han and Qiu (2007) find that firms that are
financially constrained have cash holdings that are sensitive to cash flow
volatility. Because future cash flows are not diversifiable, the level of cash
increases when the cash flow volatility rises. Cash is kept as an emergency fund
for the company. A right amount of cash to be held to avoid unanticipated
events. These unanticipated events cause many unpredictable consequences that
companies have to deal with. Emergencies such as increasing of raw material,
labors, falling in marketing demand, loss or theft goods bound the firm to hold
a certain level of cash. The amount of cash holding relies on the degree of
unpredictability of each event. The higher degree of unpredictability, the
higher level cash need to be held.

The second reason for firm
holding cash is to reduce the transaction cost. Following to the study of Myers
and Majluf (1984), each company has their own investments in short-term. Due to
the lack of available fund, they tend to raise external fund which is a costly
alternative. High transaction cost is mostly made from informational
asymmetries between firms and external investors. To avoid cost of transaction,
the companies maintain much more cash holding to cover their needs in
investing. In another study, Baumol (1952) and Miller & Orr (1966) pointed
out a classic financial model mentioned to the transaction motive. Their main
point is that firm should hold an optimal amount of cash for precautionary
reason such as making certain payment. The optimal amount of cash would be
useful for the firm to save cost. Payment normally is performed in cash. If
firms hold less cash, they must convert assets to cash in order to make the
payment. The conversion process causes the cost which is considered as a particular
form of transaction cost. It is necessary for companies to hold some cash for day
to day business, because inflows and outflows of cash do not always match
perfectly. By holding appropriate amounts of cash, firms can reduce transaction
costs. As they will have the cash needed to make current payments, they avoid
going to the market to raise cash, which would be costly. However, holding
excess cash gives rise to higher opportunity costs, as these cash holdings
could have been used to finance profitable projects. The transaction motive
foresees an optimal level of cash where the opportunity cost of cash equals the
cost of holding.

The research of Fayele
(2004) supports the last reason by considering cash holding serving as a
powerful antitakeover defense against hostile bidders. Excess cash balances
offer potential targets opportunities to counter unfriendly takeover bids. These
include the possibility to repurchase stock as well as the possibility to
acquire a competitor of the bidder or the bidder himself.

Muncef Guizani (2017)
investigates the determinants of the cash holdings for a sample of Saudi firms
over the period 2006-2014. The paper shows that corporate cash holdings are
usually based on three important theories in corporate finance: trade off
theory (Myers, 1977), pecking order theory (Myers and Majluf, 1984) and free
cash flow theory (Jensen, 1986).

cash holdings: Theory


Trade-off theory
suggests that companies holding cash set up an optimal level of cash holdings.
This level is influenced by balancing the marginal costs and marginal benefits (Opler
et al., 1999; Dittmar et al., 2003; Ferreira and Vilela, 2004; Afza and Adnan,
2007; Kariuki et al., 2015). Marginal benefits side of holding cash refer to as
the lower transaction costs, reduction in the likelihood of financial distress
and the possibility of implementing investment projects that could not be
carried out without these funds owing to the existence of financial
constraints. The marginal benefits are sufficient enough to cover the main cost
of holding cash which is the opportunity cost of the capital invested in liquid



order theory

In the same vein, pecking
order theory suggests that asymmetric information between managers and
investors makes external financing costly. That means when the internal fund is
under the investment demand, company lending outside sources. The difference in
the amount of outside and inside information of companies leads to information
asymmetry, the main in rising transaction cost. Therefore, firms should finance
investments first with retained earnings, then with safe debt and risky debt,
and finally with equity to minimize asymmetric information costs and other
financing costs. Pecking order theory demonstrates that firms do not have
target cash levels, but cash is used as a buffer between retained earnings and
investment needs.

cash flow theory

Finally, the free cash
flow theory postulates that managers have an incentive to build up cash to
increase the amount of assets under their control and to gain discretionary
power over the firm investment decision. Cash reduces the pressure to perform
well and allows managers to invest in projects that best suit their own
interests, but may not be in the shareholders’ best interest. However, neither
the pecking order theory nor the free cash flow theory suggests that there
exist target cash holding levels while the trade-off theory does. According to
this theory, firms trade off the benefits and costs of holding cash to
determine the target cash reserves, and when the actual cash holdings deviate
from the target levels, firms tend to adjust their cash reserves to the target

of Cash holding policy

Previous study has
research the determinants which affect directly cash holding or liquidity
assets of firms. For example, Kytönen (2005) conducts the empirical study on
the determinants of corporate liquidity holdings for a sample of Finnish firms
listed on Helsinki Stock Exchange. As a result, he found that that firms? size,
growth opportunities, opportunity costs, cash flows, efficiency of working
capital management, leverage, dividend policy and the probability of financial
distress are important in determining liquidity holdings in Finnish firms.
Based on study of Guizani M.(2017), determinants
of cash holding policy includes financial leverage, profitability, capital
expenditures, dividends payment, growth opportunities, firm size, net working
capital and cash flow volatility.


is a negative correlation between leverage and cash holding

Both trade off and
pecking order theories predict a negative correlation between leverage and cash
holdings. By contrast, Caglayan-Ozkan and Ozkan (2002) and Diamond (1984) show
that debt can be a substitute for cash holdings because of debt relief and
moral hazard. Similarly, according to the pecking order theory, Opler et al.
(1999) state that companies use cash to pay debt off, or continue to accumulate
cash at target level. Although companies have the same target level, the money
is still followed pecking order theory. Free cash flow theory also predicts a
negative correlation between leverage and cash holdings as companies which
funded by external source are not under the supervision thus allow managers to
hold higher cash flow.

is a positive correlation between leverage and cash holding

Contrary to the above
correlation, Ferreira and Vilela (2003) argue that trade off theory can also
predict a positive correlation between leverage and cash holdings as leverage
increases the probability of bankruptcy and therefore companies keep the cash
to reduce the probability of financial exhaustion.


is a negative relationship between profitability and cash holdings.

According to trade off
theory, there is a negative correlation between profitability and cash holdings
because profitable companies have sufficient cash flow to avoid ineffective
investment issues (Kim et al., 1998; Caglayan -Ozkan and Ozkan, 2002). High
profitability reduces the risk of payment and investing for firms.  While the firms maintain amount of cash
inflow such as profit, cash utility is more flexible through using cash for
other firm – level activities. The same results were found by Almeida et al.
(2004) for companies with financial constraint and found by Bates et al. (2009)
who also found a negative correlation between profit and cash holdings.

is a positive relationship between profitability and cash holdings.

According to the
pecking order theory, firms tend to retain higher level of liquidity while they
have higher financial performance. This is because profitable firms normally
accumulate the cash flow generated. Consequently, the most profitable companies
should have more cash to control the investment. There are several valuable
studes that prove this positive relationship. For instance, Opler et al. (1999)
argue that there is a positive relationship between cash flows and cash levels.
Ferreira and Vilela (2004) and Al-Najjar and Clark (2016) confirm this
argument. Consequently, there is a positive association between firm’s
profitability and cash holdings


Firms in such capital
intensive industries often need to maintain the required cash over a longer
period of time because their cash flow cannot be as fast as that of other

is a negative correlation between capital expenditures and cash holdings

The pecking order
theory provides a negative correlation between capital expenditures and cash
holdings because capital expenditures clearly reduce the company’s cash directly.
Moreover, firms with larger investment expenses have less or no surplus from
internally generated funds to invest in liquid asset reserves, and hence they
hold less liquid assets. Firms which follow risk aversion choose to use their
cash for financing short investment instead of using loan. According to the
content of this theory, firms rising their demand in invest operation tend to
use the cash holdings in order to make the payment or cover the fund shortage. Lee
and Song (2007) point to a negative correlation between the cost of capital and
cash holdings in companies after the Asian financial crisis. In the same vein,
Bates et al. (2009: 1999) argue that ? if capital expenditures create assets
that can be used as collateral, capital expenditures could increase debt
capacity and reduce the demand for cash ?. The major purpose is to eliminate
transaction cost.

is a positive correlation between capital expenditures and cash holdings

Conversely, the tradeoff
have a positive correlation between them because high capitalization companies
keep cash at a balance level with the level of transaction costs associated
with capital and opportunity costs of insufficient financial resources. This is
due to the content of trade off theory which supposes to balance the margin
profit and margin cost. In studying, Opler et al. (1999) argue that cash
holdings increase with the cost of capital.


is a negative relationship between dividend payments and Cash

According to the
trade-off theory, the relationship between dividend payments and cash should be
negative, since firms that pay dividend can trade off the costs of holding cash
by reducing dividend payments (Al-Najjar and Belghitar, 2011). Previous studies
such as Opler el. (1999) and Drobetz and Gruninger (2007) argue that firms that
currently pay dividends can raise funds at low cost by reducing their dividend
payments therefore they don’t need to hold high amounts of cash. In contrast,
firms that do not pay dividends need to use the capital markets to raise funds.
When firms need cash and have difficulty raising funds, or they are financially
constrained because their leverage is special high, they can try to increase
retained earnings by cutting back dividend payments. Therefore, firms that are
financially constrained can only achieve targeted cash flow by cutting dividend
payments.  Similarly, Ozkan and Ozkan
(2004) argue that these costs can be avoided for firms facing low internal
financing resources by issuing equity or even reducing payment of dividends

Fazzari et al. (1988)
observed that “if a company has a shortage of liquid assets, the company
can cope with the shortfall by reducing investment or reducing dividend payment
or by mobilizing outside capital through the issuance of securities or the sale
of assets”.

Growth opportunities

Growth opportunities are opportunities to invest in profitable projects. An investment or project has the potential
to grow significantly that leading to a profit for the investor. New investments
are often presented to potential investors as growth opportunities.

is a positive relationship between growth opportunities and cash holdings.

Based on the trade-off
theory, there is a positive association between growth opportunities and cash
holdings. The opportunity cost and financial distress cost should be considered
when evaluating the level of growth opportunities. A company investing in a new
project means that it must consider the liquidity of the company’s assets and
the amount of cash held to ensure its ability to pay for incurred during the
life of the project. In case of holding less cash, the opportunity cost due to
a lack of liquidity should be more severe for firms with high quality
investment project. These firm will also have higher financial distress costs (Williamson,
1988) which can make the external financing more expensive (Harris and Raviv,
1990). To avoid these costs, these firms normally provide liquidity in order
not to run the risk of underinvestment in the future. Therefore, to avoid any
shortfall in cash is in accordance with transaction motives of cash (Opler et
al., 1999). Second motive of avoiding financial distress is consistent with
motive of precaution (Bates et al., 2009). Similarly, the pecking order theory
argues for a positive link between growth opportunities and cash holdings.
Firms with higher growth opportunities need higher cash level to cope with any
shortfall in cash.

flow volatility

is a positive relationship between cash flow volatility and cash holdings

Based on the trade-off
theory, companies with more volatile cash flows face a higher probability of
experiencing cash shortage due to unexpected cash flow deterioration. High
level of volatile cash flows leads firm to forgo some profitable investment
projects. Opler et al. (1999) show that uncertainty leads to situations in
which, at times, the firm has more outlays than expected. In addition, firrms
with unstable cash flow will keep a large amount of cash. Cash is used to make
up for deficits when the cash flow is significant large compared to the cash
flow. This explains that the company keeps cash for precautionary motives.
Interestingly, Bates et al. (2009) suggest that firms with greater cash flow
risk hold more precautionary cash. Empirically, Saddour (2006) and Ferreira and
Vilela (2004) argue about a positive link between cash flow uncertainty and
cash holdings.

working capital

is a negative relationship between net working capital and cash holdings.

In recently years, researchers
have conducted in-depth studies to discover if working capital management
influences the level of corporate cash holdings and findings are supportive.
Capkun & Weiss (2007) examine the operating assets and cash holdings of US
manufacturing firms in the 1980-2005 periods and find a decrease in operating
assets and an increase in cash holdings. They explain the increase of corporate
cash holdings by the reduction in inventory and the increase in accounts
payable during the examined period and firms’ manager hold more cash as
security towards increased exposure to trade credit risk.

According to the
trade-off theory, an inverse association exists between cash and net working
capital. This is so because net working capital majorly consists of liquid
asset cash substitutes. The existence of liquid assets will lead firms to be
less reliable on capital markets to obtain cash (Al-Najjar 2013). Previous
researchers like Bates et al. (2009) and Ferreira and Vilela (2004) suggest
that net working capital consists of assets that substitute for cash.


is a negative relationship between firm size and cash holdings

As argued by Rajan and
Zingales (1995), because of diversification, larger firms have more stability
of cash flow and therefore they have lower probability of being in financial
distress. It would be easier for these firms to have access to diversified
funding sources (Ferri and Jones, 1979), which is often not possible for
smaller one. In a similar vein, Al-Najjar and Belghitar (2011) argue that large
firms are considered to be more diversified than their small counterparts and
in turn less prone to bankruptcy related costs. Consequently, they are less likely
to store cash reserves. In line with these arguments, Bates et al. (2009) state
that big firms are more likely to be able to liquidate part of non-core assets
to obtain cash, which reduces the likelihood of encountering financial

is a positive relationship between firm size and cash holdings

Contradicting the
trade-off view, the pecking order theory affirms that cash holdings increase
with firm size, because larger firms are expected to have been more profitable
historically and thus accumulated more cash. Opler et al. (1999) argue that
larger firms presumably have been more successful, and hence should have more
cash, after controlling for investment.