Title: A Bright Side of Financial Constraints in Cash Management (Subscription or fee required.)
Author: Mi (Meg) Luo (Villanova University)
Publisher: Journal of Corporate Finance, vol. 17, no. 5
Date Published: December 2011
Managers at financially constrained firms tend to make more prudent investments that lead to higher profitability than do their counterparts at companies with freer access to financing, this paper finds, providing empirical evidence of a silver lining for firms struggling to raise outside funds. The study also underscores the far-reaching benefits of stockpiling cash during periods of less constraint, giving firms a rainy-day fund for those prudent investments.
Financially speaking, there are two types of firms. Constrained firms have limits on the amount of money they can borrow and spend; their cash flow may be uncertain, for example, and can’t be used as collateral. Prior research has suggested that such constraints put firms in danger of underinvesting. Unconstrained firms, by contrast, often have a large amount of discretionary money at their disposal. They face the risk that some managers will spend the funds wastefully to enhance their prestige or influence. Research has shown that such firms are more likely to engage in projects that increase their size beyond the optimal level and that decrease shareholder value, especially when managers are poorly monitored.
This study suggests that the most successful firms in periods of significant investment are those that are constrained — but that have had the foresight to stockpile some cash. These firms turn out to be better positioned to create shareholder value. Their cash reserves will help prevent underinvestment. Yet knowing that the reserves are limited provides an incentive for managers to make their investments count. Simply put, financial constraints motivate managers to hold on to their cash until the right projects come along. In this sense, the constraints play a disciplinary role.
To examine whether financial constraints decreased managers’ propensity to spend on shortsighted, prestige-building projects, the author analyzed all firms in the Compustat database from 1971 to 2005 with the exception of financial and utility companies, which are subject to industry-specific regulations. The author evaluated a wide range of companies, but she focused her attention on cash-rich firms, those that had reserves in excess of their industry median. She used several proxies to establish whether firms were financially constrained. The first proxy was the size of the firm; previous research has determined that larger firms are generally less constrained than smaller firms because they are better known and have access to more market information. The second proxy was the ratio of dividend payouts over earnings — low-payout companies are thought to have difficulty gaining access to capital. Also included was a combined measure of profitability, growth opportunity, and the ability to leverage holdings.
The author then compared the performance of unconstrained and constrained firms following a period of significant investment activity — defined as a year in which a firm’s raw cash holdings dropped at least 2.5 percent. As a group, constrained firms reduced their raw cash holdings that year by an average of 12 percent, a significantly higher percentage than was posted at unconstrained firms, which presumably were investing newly borrowed money as well as stockpiled cash.
Using industry-adjusted returns on assets, the author tracked the operating performance of the firms under study from the year before they invested heavily until three years afterward. The spending at unconstrained firms was found to have a negative impact on their profitability. Prior to the cash splurge, a typical unconstrained company outperformed its industry peers by 6.8 percent. A year after the splurge, however, this advantage fell to 2.8 percent, and it stayed at that level for the next two years. In contrast, the typical constrained company underperformed its competitors by 8.6 percent in the year prior to spending. That gap shrank to 6.4 percent after a year and dwindled to 3.1 percent after three years. The gradual improvement in the performance of the constrained firms is consistent with a pattern of making “healthy investments” of cash reserves in “good projects,” the author writes.
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.”
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.