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Published: November 23, 2011

 
 

Turning Tight Money into Smart Money

If managers in unconstrained companies tend to waste cash on value-decreasing investments, the author reasoned, there might be a negative correlation between the amount of cash spent and the resulting change in performance. That is, the more cash spent, the lower the future profitability. Indeed, the author found that for every extra dollar of cash spent, unconstrained firms performed worse than constrained firms two years after the investment was made.

Previous research on corporate governance suggests that strong monitoring of managers improves the efficiency of cash deployment. For the subsample of firms in the study with available corporate governance data — reported every two years since 1990 by about 1,500 major corporations, from the S&P 500 and elsewhere — the author found no overall difference in the way that constrained and unconstrained managers were monitored. But in the case of firms with weak governance, constrained companies turned in a better performance following a cash deployment than did unconstrained companies. Similarly, although strong monitoring improved performance at unconstrained firms following a spending event, constrained firms still outperformed unconstrained firms, no matter what type of monitoring structure was put in place. This complementary relationship between financial constraints and governance lends further credence to the idea that they both act as disciplinary mechanisms in cash management.

“When we consider the possibility that managers’ interests might deviate from those of shareholders, financial constraints can have a positive effect in reducing the overinvestment problem associated with carrying cash,” the author concludes, “...by motivating selfish managers to channel cash into value-increasing projects and away from bad ones.”

Bottom Line:
When firms have difficulty raising outside funds, managers are less likely to spend money on wasteful projects than are their counterparts at companies with freer access to financing. Cash spending by managers in constrained firms is actually associated with higher future profitability, evidence of a silver lining: Managers invest more wisely when they have less money to play with.

 
 
 
 
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