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Published in: Review of Quantitative Finance and Accounting 2/2024

13-11-2023 | Original Research

Cash flow sensitivity of cash: when should we use it to measure financial constraints?

Authors: Weiping Hu, Xiao Zhang, Ye He

Published in: Review of Quantitative Finance and Accounting | Issue 2/2024

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Abstract

Since Almeida et al. (J Financ 59:1777–1804, 2004), there has been a long debate on whether the cash flow sensitivity of cash (CFSC) measures financial constraints. Like all measures of financial constraints, CFSC is not a perfect one. Thus, how to measure financial constraints with CFSC effectively is an important issue. This paper shows that when a firm does not save through external financing, the CFSC can be effectively used to measure financial constraints. However, for firms saving from external financing, CFSC does not effectively measure financial constraints, especially when firms use external funds as substitutes for internal ones. The reason is that CFSC does not only reveal the propensity to save from cash flows but also the internal-external financing relation, which is not necessarily linked to financial constraints. Two identification methods are used to confirm our findings.

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Appendix
Available only for authorised users
Footnotes
1
See, for example, Baum et al. (2011), Chen et al. (2012), Chen and Wang (2012), Erel et al. (2015), Itzkowitz (2015), Meng et al. (2020).
 
2
Literature also show a decline and disappearance of the investment-cash flow sensitivity during the 2008 credit crunch (Chen et al. 2012).
 
3
Note that to replicate results in Almeida et al. (2004), \(\Delta CASH\) and CF are scaled by current total assets. The estimates of the coefficients do not change significantly if we scale the variables with the total assets at the beginning of the period.
 
4
There is much evidence supporting the existence of these economies of scale (Mulligan 1997; Bates et al. 2009). For example, larger firms hold less cash because of economies of scale with the transaction motive.
 
5
They extract historical headquarter locations from WRDS SEC Analytics Suite and hand-collect the historical headquarter locations from the Moody’s Manuals (later Mergent Manuals) and Dun & Bradstreet’s Million Dollar Directory (later bought by Mergent)
 
6
Fortunately, the University of Notre Dame’s Software Repository for Accounting and Finance provides the augmented 10-X header dataset: https://​sraf.​nd.​edu/​data/​augmented-10-x-header-data/​.
 
7
All accounting data are CPI-adjusted into 1971 dollars.
 
8
WW index and HP index are measured with the following methods:
$$\begin{aligned} WW&=-0.091CF-0.062DIVPOS+0.021LEV-0.044SIZE+0.102ISG-0.035SG \\ HP&=-0.737SIZE+0.043SIZE^2-0.040AGE \end{aligned}$$
where CF is the ratio of cash flow to total assets, LEV is the ratio of long-term debt to total assets, DIVPOS is a dummy indicating positive dividends, SIZE is the natural log of total assets, AGE is the number of years preceding the observation year that the firm has a non-missing stock price on the Compustat file, ISG is the firm’s 3-digit industry sales growth, and SG is the firm sales growth.
 
9
KZ index is not included as in Almeida et al. (2004), the financially constrained firms classified with KZ index do not show a positive CFSC.
 
10
The financing deficit is defined as the growth in assets less the growth in current liabilities less the growth in retained earnings.
 
11
We acknowledge that there is a small proportion of firms that show negative correlations between cash savings and net external financing. Due to the lack of theoretical foundation, we do not consider the situation where the correlation coefficient is strongly negative.
 
12
We also calculate the 15-year rolling correlation coefficient between cash savings and external financing to capture time-variant firm heterogeneity. In addition, we use \(\pm 0.2\) as cutoffs to ensure that firms in either group have correlation coefficient estimates that are statistically reliable. Alternative cutoffs are used as robustness checks to alleviate the potential measurement error associated with small sample estimations of the correlation coefficient (See Table 14).
 
13
To compute this variable, we exclude firms when the denominator (the sum of cash flow) is negative to ensure that the weight is increasing in the amount of cash flow (Baker and Wurgler 2002).
 
14
Detailed definitions of these variables are provided in Appendix E
 
15
Many studies show that equity issuance has gradually become a major source of cash savings because of precautionary motives (DeAngelo et al. 2010; McLean 2011; Bolton et al. 2013; Eisfeldt and Muir 2016).
 
16
Earnings-based covenants usually specify debt limits as a function of internal funds.
 
17
See Appendix A.2 of Lian and Ma (2021) for details about the classification procedures.
 
18
The original insight of using the payout ratio to measure financial constraints is built on the notion that the payout policy is a central liquidity management tool (Fazzari et al. 1988). Recent empirical analyses challenge this notion, nonetheless. Almeida et al. (2016), for example, show that stock repurchases are conducted not only to manage liquidity but also to manage earnings-per-share. In particular, the unprecedented increase in stock repurchases over the last 20 years suggests that payout behavior may no longer provide a helpful indicator of constraints (Farre-Mensa et al. 2014).
 
19
These measures are obtained from Joel Hasbrouck’s Web site. They are available through 2006, so this reduces the number of observations when we use these measures.
 
20
Almeida et al. (2021) reexamine the empirical evidence on the ACW model presented in Almeida et al. (2004) and also find the constraint measure based on the payout ratio yields weak support for the ACW model.
 
21
Note that Almeida et al. (2004) focus only on manufacturing firms (SIC: 2000 to 3999). Table 15 shows that our results are robust after using the same filter.
 
22
See Heider and Ljungqvist (2015) Appendix A for a list of the relevant tax increases.
 
23
Given that tax shields can only benefit firms that have (or expect soon to have) profits to shield from tax, the debt test cannot be applied to chronically loss-making firms. Following Farre-Mensa and Ljungqvist (2016), we excludes firm-years with a zero marginal tax rate. Note that the marginal tax rates data are from Graham (1996a, 1996b). Missing values are filled in as recommended in Graham and Mills (2008).
 
24
None of our corporate income tax increases coincides with a bank tax cut.
 
25
There are four corporate tax increases that coincide with the lifting of bank branching restriction in the same state: MO (1990), MT (1990), NE (1990), and KS (1992). (See Kerr and Nanda (2009) for a complete list of deregulation events)
 
26
In Warusawitharana and Whited (2015), the tax rate on dividends is 35%, and the linear cost is around 5%. Thus lower bound of overvaluation is approximately \(\frac{1}{(1-\tau _d)(1-a)}=160\%\).
 
27
For example, Rhodes-Kropf et al. (2005), Hertzel and Li (2010), Fu et al. (2013).
 
30
Data can be found at Havard Dataverse at https://​dataverse.​harvard.​edu/​dataset.​xhtml?​persistentId doi:10.7910/DVN/T9KXMF/.
 
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Metadata
Title
Cash flow sensitivity of cash: when should we use it to measure financial constraints?
Authors
Weiping Hu
Xiao Zhang
Ye He
Publication date
13-11-2023
Publisher
Springer US
Published in
Review of Quantitative Finance and Accounting / Issue 2/2024
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI
https://doi.org/10.1007/s11156-023-01219-3

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