Financial Constraints Affecting on Cash Holdings - Essay Example

Do Financial Constraints Affect Cash Holdings? Han and Qiu (2007) opine that investment levels, cash holdings and financial holdings may be to some correlations while Almeida et al. (2004) claim to have observed certain relationships to have developed between a firm’s cash holdings and its financial constraints. In order to determine whether firms restrained by financial constraints behave differently to those not subject to such constraints, a dummy variable needs to be added. Those firms that have non-negative net income shall be denoted by the variable 1, while all other firms shall be represented by 0. The suitability of a new model must be determined before carrying out any tests owing to the complex nature of the measurements involved. The correlations will need to be carried out between loss dummy and dividend payouts as well as between loss dummy and firm size and positive relationships will need to be determined (see Appendix 4 for reference). This means that large firms are more likely to be without loss while also managing to pay dividends, an observation consistent with the results obtained by most researchers and providing evidence that the loss dummy variable can function as a proxy for financial restraints. In line with the other various researchers, we found out that firms which incur a loss, most of the times hold more cash than financially stable firms. Further examination into the correlation between loss dummy, the investment opportunity and cash flow volatility, we were able to found out that a negative correlation exists between loss dummy and the investment opportunity as well as a negative correlation between loss dummy and cash flow volatility. From this examination we can assume that financial constraints (loss dummy=0) have a positive relationship with cash flow volatility investment opportunity set (see Appendix 5). Financial constrained firms should hold some cash so that they are able to invest in investment projects which are profitable. Do Cash Holdings Differ Across Industries? The estimate models show us that cash flow volatility does in fact affect a firm’s cash holdings. Cash volatility differs from industry to industry and in order to depict this, we add a dummy variable, industry, into our model so as to determine the differences in cash holdings in each industry. The variable for industry, I, shall be used in out sample meaning that for the 32 industries listed in the London Stock Exchange, we would need to create 21(k-1) dummy variables. According to the results of the test, we can see that not all dummy variables are of significance. The ones that are significant though, tell us the difference in cash holding across industries can be explained by the differences a particular industry has compared to the base industry. A look through the LSDV model and ANOVA outputs (appendices 6 and 7 respectively) will tell us that the cash holdings in industries such as software and computer services, pharmaceuticals and biotechnology, hardware, etc. are far larger than our average cash ratio of 13.88%. This holds consistent with the CNBC.com (2010) reports where an analysis of cash holdings in S&P 500 firms was carried out and the results showed 10 of the top 15 firms to be from the IT industry while the rest were from the healthcare sector. According to the reports, firms in the IT industry hold, on average, 31.74% of their assets as cash and its equivalents. For the healthcare sector, this ratio falls to 17.52%. The variables I28 and I30, representing the industries software and computer services, and technology hardware and equipment respectively, have positive coefficients (See appendices 6 and 8). These indicate that firms in the IT sector tend to hold higher levels of cash and cash equivalents. The reasons to explain this behaviour are as follows. The positive coefficients of their R&D expenditure tell us that Research and Development expenses in this industry are significantly higher. The UK government report of 2009 confirms this by classifying firms in the pharmaceuticals and biotechnology, software and computer services, technology hardware and equipment, and banking sectors as the biggest spenders. Using R&D expenditure to sales as a proxy for investment opportunities, it can be concluded that higher spending on R&D might lead to more lucrative investment opportunities thereby leading to higher levels of cash holdings. Moreover, the service- based and technology-based firms are starting to dominate today’s economy. This means that these firms market value would be considerably higher than their book values. Another ratio which can be used to measure growth opportunity is market-to-book ratio. These firms will also have a higher market-to-book ratio. This means that these firms have better future investment opportunities and these firms need to hold on to more cash in order to finance the projects which can be profitable. On the other hand it is noted that high leverage levels will have a major negative impact on cash holding of these industries, which means that firms in the technology industry may have difficulty in borrowing money for future investment projects. According to W.P Carey, (2010), IT industries have a high chance to hold huge amounts of risky and intangible assets. Likewise, these industries would hold less fixed assets which could be used as collateral for borrowing funds. They also need to be less reliant on capital markets and hold on to more cash for future investment purposes. On the other hand Bates et al. (2009) pointed out that to avoid unforeseeable shocks these industries hold on to precautionary cash. The reason being that these firms cannot lay off their employees as they may be involved in an R&D project and if you lay them off, they won’t be available the next year to restart the project. So technology-based firms hold on to precautionary cash. It was also seen that firms in the biotechnology industry and pharmaceutical industry have a higher cash balance. The ANOVA output in Appendix 7 showed that these two industries are holding about 40.23% in cash and cash equivalents which is considerably higher than other industries. The reason for such high cash balance is that these industries have huge research and development costs. Schroth and Szalay (2007) mentioned the fact that larger cash holdings would help the firms in pharmaceutical industry to get the patent, which is of primary importance for a pharmaceutical company. Firms in the fixed line telecommunications industry (I9) have cash holdings amounting to 16.15% of their total assets. This industry like others have a high R&D expenditure and the positive relationship between investment opportunity and cash holdings is the reason for such high cash holdings. This trend of above average cash holdings is also seen in service sector industries like the health equipment and services (I16) and the industrial transportation (I19) industry. The need for high cash holding is that the independent variables R&D and leverage affect the cash holdings in a similar way as they do in the IT sector. Like technology-based firms, service sector firms also have less potential collateral and are faced with barriers when it comes to finding access to the capital markets. So, they have high cash balances that act as a protection when there are financial difficulties. According to Compaine and Gomery (2000), the managers in the media industry comparatively more power than and media companies are also able to obtain their editorial objectives without giving any response to the company’s shareholders. Compaine and Gomery (2000) also point out that media firms are run by managers and these managers are also the owners of these firms. There is also intense competition in the media industry in the UK and the mangers of the media firm try to have larger cash balance to make the firm bigger and in hindsight to enhance control over the firm. Though it may be influenced by the measurement of cash holdings, a negative sign has been observed in the food and drug retailer industry. This might be because inventories in this industry are large in size as mentioned by (Elliott and Elliott, 2008) and the basis for our dependant variable is the ratio of cash and its equivalents to total assets, thus indicating a negative sign. We predict that the results would be markedly different if we deduct inventory from total assets in the denominator when performing calculations. According to our analysis, there are some industry-specific characteristics that hold more significance when it comes to the matter of corporate cash holdings. Unreported industries on the other hand seem to follow the pattern similar to that of the whole sample. ------------------------------------Please Leave a Positive Feedback---------------------------------------- Read More