Examining the Sources of Financial Flexibility
EXAMINING THE SOURCES OF FINANCIAL FLEXIBILITY
- A STUDY OF FIRMS LISTED IN SWEDEN
Karim Philip Sayyad, Joel Aneheim Ulvenäs
June 2012
Master Thesis in Finance
School of Economics and Management, Department of Business Administration
Lund University
Abstract
This study aims to determine the significance of different sources of financial flexibility that
enables firms to respond to negative shocks or investment opportunities in form of unexpected
periods of insufficient resources. The empirical study is based on a model that proxy for firms’
investment and dividend policies to further examine how possible cash shortfalls is resolved. The
sample covers the OMXS30 during the time period 1995-2011. The model is extended, using
cross-sectional determinants, recognizing the importance of financial flexibility and its potential
impact on financial policies. The findings suggests that there exist significant cross-sectional
differences in how firms resolve cash shortfalls and that asset sales appear to be the most
common method for firms to raise funds in face of cash shortfalls. Possible explanation for this is
provided in agency theory and pecking-order theory, calling for further research.
Seminar date: 2012-05-31
Key words: Financial flexibility, Financial policy, Dividend policy, Cash shortfalls
Supervisor: Göran Anderson
Examining the Sources of Financial Flexibility
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Examining the Sources of Financial Flexibility
Table of contents
1 Introduction .................................................................................................................................... 3
1.1
1.2
1.3
1.4
1.5
2
3
Background..................................................................................................................................... 3
Problem discussion ..................................................................................................................... 4
Purpose ............................................................................................................................................ 7
Delimitations.................................................................................................................................. 7
Thesis outline................................................................................................................................. 8
Theory ......................................................................................................................................... 9
2.1
Theoretical background ............................................................................................................ 9
2.2
Motives for financial flexibility ............................................................................................. 11
2.3
Sources of financial flexibility ............................................................................................... 14
2.3.1 Cash holdings and liquidity management .........................................................................................14
2.3.2 Capital structure and debt ........................................................................................................................16
2.3.3 Flexible equity payouts and other financial policies ....................................................................19
2.4
Significance of financial flexibility and economic crises ............................................. 20
Sample description and methodology ...........................................................................22
3.1
Data .................................................................................................................................................. 22
3.1.1 Sample and excluded observations ......................................................................................................22
3.2
Research approach .................................................................................................................... 23
3.3
Calculating cash shortfalls ...................................................................................................... 24
3.3.1 Input variables ...............................................................................................................................................24
3.4
Model for resolving cash shortfalls ...................................................................................... 25
3.4.1 Choice of model .............................................................................................................................................25
3.4.2 Variables ...........................................................................................................................................................26
3.4.3 Determinants of financial flexibility .....................................................................................................27
3.5
Cross-sectional determinants of resolving cash shortfalls ......................................... 29
3.5.1 Measuring financial flexibility ................................................................................................................29
3.5.2 Other firm characteristics and determinants ..................................................................................30
3.6
Hypothesis .................................................................................................................................... 31
3.7
Methodological Problems........................................................................................................ 32
3.6.1 Validity ..............................................................................................................................................................32
3.6.2 Reliability .........................................................................................................................................................33
4
5
6
Empirical findings.................................................................................................................34
4.1
Shortfalls........................................................................................................................................ 34
4.2
How firms resolve cash shortfalls ........................................................................................ 37
4.3
Financial flexibility and results from cross-sectional determinants of resolving
cash shortfalls .............................................................................................................................................. 40
Analysis ....................................................................................................................................42
5.1
The impact of financial flexibility on financial policy ................................................... 42
5.1.1 Hypothesis 1 ...................................................................................................................................................43
5.1.2 Hypothesis 2 ...................................................................................................................................................44
5.1.3 Hypothesis 3 ...................................................................................................................................................45
5.1.4 Hypothesis 4 ...................................................................................................................................................46
5.1.5 Hypothesis 5 ...................................................................................................................................................47
5.1.6 Hypothesis 6 ...................................................................................................................................................48
Conclusion ...............................................................................................................................50
6.1
Future research ........................................................................................................................... 51
7
References ...............................................................................................................................52
8
Appendix ..................................................................................................................................58
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Examining the Sources of Financial Flexibility
1 Introduction
In this chapter the motives behind the research topic are presented along with
purpose of the thesis. This is followed by delimitations and ended with a section
describing the disposition of the thesis.
1.1 Background
In surveys addressing American and European CFO’s covering the topics of cost
of capital, capital budgeting and capital structure, findings suggest that the sole
most important determinant of a firm’s capital structure is the aspiration to
attain and protect financial flexibility (Graham and Harvey (2001), Bancel and
Mittoo (2004) and Brounen et al. (2004)). Financial flexibility refers to the ability
at which a firm can respond to unexpected changes in cash flows or investment
opportunities in a timely and value-maximizing manner. Firms that through
financial policies preserve flexibility are thereby able to avoid financial distress
and to readily fund investment in the face of negative shocks or profitable
opportunities, respectively. Financial flexibility should by this definition be
considered forward-looking in that sense that “managers not only react to
financing frictions when they occur, but they also anticipate future frictions and
adjust their firms’ policies so that the impact of these frictions is minimized”
(Almeida et al. (2011)).The on-going economic and financial crises that began in
late 2007 clearly represent an exogenous shock to firms’ cash flows and
profitability. While generally reducing the expected return on investment
opportunities, crises in general also create opportunities for firms with the
ability to invest (Mitton (2002)). The historic magnitude, i.e. the breadth and
depth, of the current crises emphasizes the importance of understanding how
shocks impact the financial decisions made by corporations in order to avoid
situations that may lead to sub-optimal investments or poor performances.
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Examining the Sources of Financial Flexibility
1.2 Problem discussion
In the case of perfect capital markets where no financing frictions are assumed to
exist, Modigliani and Miller (1963) show that firms will always invest at the firstbest level. The authors argue that in such frictionless environment, firms can
costless adjust their financial structure to meet unforeseen needs, henceforth
have complete financial flexibility. Firms will therefore always be able to raise
capital
for
all
positive-NPV
projects,
i.e.
value-increasing
investment
opportunities, regardless of the level of cash flows. This follows the assumption
that firms will pay out any residual cash flows as dividends and thus, investment
policy acts as an exogenous variable in relation to dividend policy, but not vice
versa. Put in other terms, negative shocks to cash flows are assumed to affect
dividends but not investment levels in a perfect capital market unless the shock
is of that extent that it could not be covered by cutting dividends to zero.
Financial flexibility as a concept becomes interesting only when capital market
imperfections are introduced, i.e. in the presence of financing frictions, since
firms in such market are constrained from pursuing all positive-NPV projects.
Consistent with this view, it is valuable to firms to choose financial policies that
preserve financial flexibility to respond to negative shocks in the form of
unexpected periods of insufficient resources.
With information asymmetry as a financing friction, which results in costly
external financing, firms may tend to maintain healthy cash balances that in turn
can serve as a buffer in periods of insufficient resources. Cash flow shortfalls are
thereby met first by reductions in cash balances and, in some cases, by
reductions in dividends. An alternative view, not mutually exclusive, is that cash
holdings themselves are costly because financial frictions in forms of potential
agency problems. Hence, value-maximizing firms will maintain relatively low
cash balances meanwhile preserving unused debt capacity in case of future
negative shocks. Maintenance of dividends is according to this view, a first-order
priority since a relatively stable dividend policy will allow the firm continued
access to the capital market. Cash flow shortfalls are thereby met primarily by
new borrowings. Hence, the two alternative views above stipulate two different
sources of financial flexibility.
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Examining the Sources of Financial Flexibility
Following the findings in Leary and Roberts (2005), Flannery and Rangan
(2006), and Faulkender et al. (2008), Denis and Mckeon (2011) set up the
hypothesis that firms might deviate from target leverage in the case of large
adjustment costs but that pro-active changes in debt-levels should be
represented either by a “deliberate rebalancing towards the firm’s long-run
target or a movement to a new target leverage”. Based on that both the leverage
increase and the subsequent rebalancing behaviour of their sample suggest that
managing towards a long-run target is not a first-order determinant of capital
structure, the authors rejects this hypothesis. Evidence instead suggests that, in
consistency with DeAngelo and DeAngelo (2007), financial flexibility is a missing
link in connecting observed firm behaviour with capital structure theory.
Following the results, it should therefore be possible to see unused debt capacity
as an important source of financial flexibility and thus avoid cutting dividends
and investment. Using this argument, the findings of Byoun (2007), in which
small firms have lower debt ratios because of additional equity financing, could
serve as evidence for the financial flexibility theory. Another model of capital
structure dynamics by DeAngelo et al. (2011) uses debt for serving as a source of
transitory finance when firms face shortfalls caused by random shocks to their
investment opportunity set. An increase of transitory debt allows the firms to
“undertake unexpected investment opportunities, while subsequent financing
surpluses are used to reduce debt.”
Relative the perceived importance of financial flexibility according to Graham
and Harvey (2001), there is little systematic study of the subject, its sources and
their possible impact on firms’ financial policies, especially in the capital
structure literature. One possible explanation, put forward by Byoun (2007),
suggests that that dealing with the concept of financial flexibility is both less than
practical and based on “speculation on the ability of a firm to respond to
hypothetical future events”. In real options literature however, the concept of
“investment flexibility” has been developed, see Childs et al. (2005), Gamba and
Triantis (2008), where the latter use real options models designed to measure
the value of “investment flexibility” under the assumption of perfect “financial
flexibility”.
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Examining the Sources of Financial Flexibility
One of the research papers that examine the possible sources of financial
flexibility is Daniel et al. (2011) in which the data sample is consists of data
reported from U.S. firms. As reported by Kahl et al. (2008) commercial paper
plays an important role in corporate financing and investment decisions for U.S.
firms, often used as a bridge to long-term financing. A commercial paper
program allows firms’ to access short term debt at low marginal costs and
minimum regulatory requirements. Commercial paper thereby substitutes for
cash holdings and bank credit lines, which is a result that is less likely to be
observed among Swedish firms. This is so since the corporate bond market have
most recently started to evolve, currently corresponding to around 20% of the
companies' financing (Sandstrom (2012)), a significant lower average than for
U.S. firms. Studying a sample of Swedish firms and comparing the results with
the ones in Daniel et al. (2011) would therefore be interesting since the sources
of financial flexibility might vary since financing options are different. Another
source of debt capacity associated with low frictions is credit lines, which also
appear to be substitutes for according to the findings in Sufi (2009).
Based on the assumption that flexible firms are better equipped to cope with the
consequences of negative shocks (Arslan et al. (2008)), there is of interest to
study sources of financial flexibility and their economic significance, and thereby
investment policies during financial/economic crisis. Such argument could be
based on the evidence that financial constraints in capital markets can magnify
the macroeconomic effect of shocks to cash flow or liquidity (Fazzari et al.
(1988)). Another argument could be the findings of Ang and Smedema (2011)
that in their paper finds that cash holdings are economically small but
consistently negatively related with the probability of a future recession. They
find that these results are driven by financially constrained and cash poor firms
and that some evidence suggests that unconstrained and cash rich firms prepare
for future recession.
To the knowledge of the authors of this thesis, no studies investigating the
sources of financial flexibility for firms listed in Europe, and specifically Sweden,
has yet been conducted. By comparing the research findings in this thesis to the
results shown by Daniel et al. (2011), this study contributes to the understanding
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Examining the Sources of Financial Flexibility
of finance policies and how they vary across geographical markets during
periods of uncertainty. In addition, the thesis provides a broad overview of
different sources of financial flexibility and ties recent research on capital
structure, cash shortfalls and corporate investment to financial flexibility.
Further, by applying a procedure to classify firms according to their financial
flexibility status, this study contributes to finance literature by examining the
relationship between financial flexibility and financial policies.
1.3 Purpose
This thesis is to provide comprehensive overview on the theory and concept of
financial flexibility and the sources used to establish it. Through empirical
analysis, the main purpose is to determine the significance of different sources,
the impact of financial flexibility on financial decisions and however financial
crises influence managers’ decisions re-allocating firms’ funds. In other terms,
from where do firms draw the necessary funds in order to attain/maintain
financial flexibility during periods of low cash flows or unexpected growth
opportunities?
1.4 Delimitations
The selected firms to be scrutinized for the study are the listed companies on the
OMXS30, from beginning of 1995 until 2011. Another limitation is missing
company information during some years due to insufficient data. This results in
exclusion of certain parameters in the model proposed by Daniel et al. (2011),
e.g. access to line of credit and dividend history prior to 1995. For the same
reason as mentioned above, it is not possible to retrieve dividend growth rates
and take that into consideration when studying shortfalls. In terms of nonoperating cash, the calculated value become relatively large as the amount of
acquisitions is not excluded due to missing values in available databases and
sources for this information. We recognize the importance of corporate
governance questions based on the findings in Ditmar et al. (2003) and
Pinkowitz et al. (2006) but this is outside the scope of this paper.
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Examining the Sources of Financial Flexibility
1.5 Thesis outline
The remainder of the thesis is organized as follows. In Section 2 the relevant
theoretical framework and background is given. Section 3 covers the empirical
analysis, where the hypothesis is developed. In addition, the data construction
and the empirical strategy are described along with a presentation of the
regression model used, its variables and possible shortcomings.
The findings and main results of the empirical study are reported in section 4
and discussed in section 5 where potential explanations are analysed. The final
section contains a summary and conclusion as well as implications for future
research.
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Examining the Sources of Financial Flexibility
2 Theory
In the second chapter the theoretical framework of financial flexibility is presented.
Initially the theoretical background and motivations of the concept are scrutinized
followed by presentation of different theoretical approaches for quantifying
financial flexibility.
2.1 Theoretical background
The focus in more recent studies has been two associated primary frictions,
namely agency costs and asymmetric information. The former, constituted by
Jensen (1986), suggests a framework where managers have incentives to
misallocate free-cash flows, e.g. by overinvesting or expropriating. As a
preventive action, firms bear debt since debt payments are a better commitment
device than dividends. This can be explained by debt payments characteristics as
contractual obligations to creditors, whereas Jensen (1986) argues that
dividends can be decreased at the discretion of managers. In standard trade-off
models, firms will balance the benefits of debt, e.g. the above-mentioned
reduction of agency costs and tax benefits, against the costs of costs of debt in
forms of distress costs and the costs of underinvestment. A firm will thereby set
for a capital structure that is value maximizing. The size and the impact of the
various debt-related costs and benefits have been reviewed in former studies,
e.g. Almedia and Philippon (2007), as well as support of agency cost-based
lifecycle theories, (DeAngelo et al. (2006) and Denis and Osobov (2008)).
The traditional trade-off models of capital structure have been criticized based
on their poor performance in explaining observed debt ratios (Ang and
Smedema (2011)). The showed difficulties in explaining for example why firms
tend to issue stock after exogenous decreases in leverage or why leverage ratios
are negatively related to profitability, has lead to that financial economists have
increasingly turned to dynamic models to address these shortcomings. These
dynamic models incorporate financing frictions, frictions in real investment, or
both (Chauvet and Potter (2005), Ang et al. (2006), and Kauppi and Saikkonen
(2008)).
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Examining the Sources of Financial Flexibility
In the asymmetric information framework, informational imperfections in both
equity and credit markets lead to a divergence between the costs of external and
internally generated funds. Consequently, managers of firms with high cost of
external finance, acting in the interests of current shareholders, will ration
external finance and thereby rely more on internal generated funds: cash flow
and cash holdings (Greenwald et al. (1984) and Myers and Majluf (1984)). This
may lead to firms being forced to decrease investments in case of a shortfall in
cash, (Fazzari et al. (1988) and Froot et al. (1993)). The former paper suggests
that dividend-paying firms are less constrained than non-paying firms since
high-payout firms can use their dividend-reserved funds to instead fund
profitable investment opportunities. The pecking-order model by Mayers and
Majluf (1984), suggests that adverse selection costs of issuing external equity are
significantly greater than similar costs related to debt. Firms will thus avoid the
necessity of external funds in order to maintain “financial slack”.
More recent studies have shown that models based on asymmetric information
theory suffers from empirical shortcomings and that it should be regarded
“dead” as a stand-alone theory of capital structure (Fama and French (2005)).
One key argument that the authors emphasized was the theory’s inability to
explain why equity issues are not exclusively used as a last-resort financing
vehicle (Graham (2000), Minton and Wruck (2001), Strebulaev and Yang (2012),
Mura and Marchica (2010), Denis and McKeon (2011)). DeAngelo and DeAngelo
(2007) also stresses that the same information asymmetry that engenders
distress costs that ex ante reduce optimal leverage also creates an ex ante value
to financial flexibility, which reduces those costs. By recognizing this linkage, the
authors’ argument that this will lead to capital structure decisions that differ
significantly from those of traditional trade-off theories. Ignoring the same
would lead to that distress cost theories fail to recognize that managers will
select ex ante financial policies that provide the ex post flexibility in order to
“mitigate the real resource costs caused by security valuation problems, both in
financial distress and in healthy firms that require outside capital” (DeAngelo
and DeAngelo (2007)).
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Examining the Sources of Financial Flexibility
Viewing cash holdings as a potential source of financial flexibility, the potential
costs and benefits of holding cash have been debated over time, see for example
Keynes (1936), Jensen and Meckling (1976), Myers (1984), Jensen (1986), and
Myers and Majluf (1984). Keynes argument is that a firm that faces incremental
costs when accessing external capital markets can increase its value by
maintaining a liquid balance sheet. In an effort to generalize this argument, since
Keynes’ discussion mainly focused on corporate cash policies, Almeida et al.
(2011) argue that “any decision that affects a firm's ability to finance its projects
will be affected by the distribution of financing demand and costs across time”.
Related studies that examine the effects of various financial variables on the level
of cash reserves are examples of support for the generalization, e.g. Kim et al.
(1998) and Opler et al. (1999). More recent papers have been focusing on the
influence of corporate governance, at both country and firm levels, on corporate
cash holdings in firms (Dittmar et al. (2003), Pinkowitz et al. (2006), Dittmar and
Mahrt-Smith (2007), Harford et al. (2008), Kalcheva and Lins (2007) and
Kusnadi and Wei (2011)).
2.2 Motives for financial flexibility
In academic literature, scholars have defined financial flexibility differently in a
wide variety of forms based on certain motives that frequently coincide or that
are more or less correlated. Early studies by Donaldson (1971) refer to “financial
mobility” to describe “the capacity to redirect the use of financial resources in a
manner consistent with the evolving goals of management as it responds to new
information about the company and its environment”. Mainly relating the term
to capital structure decisions, Donaldson (1971) stresses the value of finding the
optimal mix between debt and equity financing sources in order to maximize
wealth at a particular point in time. Donaldson (1971) also develop a “strategy
for financial mobility” which in turn refers to a firm’s ability to establish and
generate funds, both internal and external, during periods of uncertainty. This
can be seen as a development of the theory by Chandler (1962) and should be
viewed as evidence that the concept and theory of financial flexibility in not a
recent finding that has emerged during the last decade.
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Examining the Sources of Financial Flexibility
In the paper by Heath (1978) financial flexibility is linked to cash flows and a
more specific interpretation is applied. Heath (1978) refers to a financially
flexible firm as one that has the ability to “take corrective action to eliminate any
excess cash payments over receipts” with minor adverse effects. The American
Institute of Certified Public Accountants (AICPA (1993)) adopts Heath’s view by
defining financial flexibility as “the ability to take action that will eliminate an
excess of required and expected cash payments over expected resources”. A
corresponding definition is the one set by The Financial Accounting Standards
Board (FASB (1984)) where financial flexibility is “the ability of an entity to take
effective actions to alter amounts and timing of cash flows so it can respond to
unexpected needs and opportunities”. There is a clear distinction between
Donaldson’s “financial mobility” and the definition by Heath where the latter
refers to an organisation’s ability to access financial resources or to vary cash
flows. The former instead refers to the ability to redirect the use of those
resources in response to new information. Another significant difference is that
Heath (1978) along with AICPA (1993) and FASB (1984) use the term in
exclusively reference to the balancing of cash flows, excluding sources such as
debt and equity financing.
In more recent treatments of financial flexibility in finance literature, focus
mainly figures around a firm’s ability to meet its expected future needs through
cash flows, unused borrowing capabilities, and/or liquid assets (Byoun (2007)).
Such an example where research emphasis is on one of these factors, is the
research paper based on a conducted survey by Graham and Harvey (2001). In
the paper financial flexibility is referred to as “preserving debt capacity to make
future expansions and acquisitions” or “minimizing interest obligations, so that
they do not need to shrink their business in case of an economic down turn”. A
similar definition is used by Mura and Marchica (2010), based on the hypothesis
of Modigliani and Miller (1963). Gamba and Triantis (2008) in turn, use a more
general definition in their attempt to model the value of financial flexibility,
hence including additional factors than debt as financial sources to define
financial flexibility as “the ability of a firm to access and restructure its financing
with low transaction costs”. According to their results, it follows that firms
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Examining the Sources of Financial Flexibility
categorized as financially flexible, have in greater extent the ability to “avoid
financial distress in the face of negative shocks and to fund investment at low
cost when profitable opportunities arise”.
The significance of flexibility has also been recognized in management and
organization literature, which include other functional areas of business, e.g.
strategic flexibility, organizational flexibility, and operating flexibility (Harrigan
(1985), Pasmore (1994), and Trigeorgis (1993) and Kulatilaka (1993)). In the
same field of literature, Volberda (1998) views flexibility in two different
perspectives, internal and external. On the one hand “internal flexibility” refers
to the firm’s ability to adapt to the demands of the environment. On the other,
the firm’s capacity to reduce its vulnerability by influencing the environment is
referred to as “external flexibility”. Accordingly, Volberda (1998) definition
succeeds in recognizing the “reactive”, “preventive” and “exploitive” nature of
flexibility (Byoun (2007)). In the aspect of “reactive” and “preventive”, managers
should thereby be able to react to shocks, as to when the occur, as well as to
minimize the impact of future shocks by adjusting the firm’s financial policies at
present, compare with Almeida et al. (2006) that focus on frictions. The
“exploitive” nature of financial flexibility refers to the firm’s ability utilize the
uncertainty in competitiveness or environment to rapidly capitalize on rising
opportunities (Byoun (2007)).
This notion of flexibility is followed in Byoun (2007) where financial flexibility is
defined as the “degree of capacity and speed at which the firm can mobilize its
financial resources in order to take reactive, preventive and exploitive actions to
maximize the firm value”. Byoun (2007) thereby combines the finance literature
with management theory, using the definition of uncertainty not solely about
future cash flows, but also including organization and environment. This is
explained by the fact that if a “business environment is more turbulent and
competitive… there will be more demand for flexibility to cope the uncertainty”
(Byoun (2007)). The future oriented concept of financial flexibility thereby
constitutes that the decisions made in present on financial flexibility, impact on
future options available to management in response to unforeseeable change
(Gerwin (1993)). Following this line, an incorporation of financial flexibility can
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Examining the Sources of Financial Flexibility
create options that are valuable in the future (Byoun (2008)) and “maximizing
the firm value should be the ultimate goal of optimizing financial flexibility“
(Byoun (2007)).
2.3 Sources of financial flexibility
The different sources of financial flexibility with its significance and degree of
impact should be studied in order to determine how firms attain, and maintain,
financial flexibility in face of negative shocks, recessions and states of high
growth. Therefore, it is important to distinguish and investigate the sources of
flexibility with associated costs and benefits in order to provide a full
understanding of the concept.
2.3.1 Cash holdings and liquidity management
There is a need to explore the related costs and benefits of cash reserve holdings,
because these are viewed upon differently between shareholders and
management. Management prefers cash because of lower firm risk and increased
discretion (Opler et al (1999)), whilst shareholders prefer lower levels of cash
due to the risk of agency problems.
Excessive cash reserves, i.e. accumulated free cash flow, are what (Harford
(1999)) refers to as “stockpiled free cash flow” and is a severe agency cost in
cash-rich firms. Cash reserves are excessive when management is accumulating
more cash than is needed to fund investments that generates positive net
present value. Management must find ways to spend cash, if there are cash
holdings. With no profitable investments available, poor investments will be
made. Jensen (1986), states that entrenched managers tend to waste cash by
investing in negative net present value projects. The excess cash makes it
possible for managers to finance losses. Holding excess cash reserves to save for
future investments permits management to maintain the flexibility to pursue
objectives at their discretion. Harford (1999) concludes that cash-rich firms
engage in behaviours which are value-decreasing for the stockholders. The costs
related to capital market imperfections when raising external financing and
uncertainties in the exact amount of cash needed to fund future projects
(Harford (1999)) may be high for some firms. Hovakimian (2009) suggests that
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Examining the Sources of Financial Flexibility
firms hoarding cash is interpreted as being financially constrained and not
having sufficient access to external capital markets.
There is research that stresses the advantages with holding cash. Keynes (1936)
underpin the argument already back in 1936, that less transaction costs are
related to cash holdings and firms are able to meet liquidity needs. Large cash
holdings serve as a buffer in periods of financial needs. Management should,
according to financial literature, strive to keep cash holdings at a level where the
marginal benefit of holding the cash is equal to the marginal cost to avoid agency
problems. The main advantages of holding cash, according to Baskin (1987), is
that it reduces transaction costs, accommodate for competitive advantages and
that there is cash readily available when unexpected negative changes in cash
flows occur. Accordingly, it can also provide for management to undertake
sudden growth opportunities. Keeping financial slack is, according to the pecking
order theory, existent in order to avoid raising funds externally (Myers and
Majluf (1984)). Another argument commonly stipulated in financial literature for
holding cash is that firms can choose to avoid hedging with expensive
derivatives, and in many cases, derivatives do not exist for all types of risks.
Furthermore, cash and its equivalents can therefore serve as a function to hedge
instrument towards, e.g. variance in cash flow.
DeAngelo and DeAngelo (2007) suggest that it is optimal to have a financial
policy consisting of low cash holdings. On the other hand, Opler et al. (1999)
explains that a cash shortage is more severe than excessive cash. The authors
advocate that if there is a cash shortage, the shareholders suffer as management
might be forced to cut dividends or refrain from taking on investments due to
lack of internal funds or raise new funds in the capital markets. Firms have
different costs to external markets and it has been found that firms with poor
access have higher cash holdings, while diversified firms have lower (Denis
(2011)). The argument for this is that diversified firms have a lower value of cash
than single-segment firms because diversification reduces financing frictions,
leading to lower cost to external markets (Tong (2011).
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Examining the Sources of Financial Flexibility
According to Acharya et al. (2007) cash holdings is a critical aspect in optimal
financial policies as it eases the ability for management to undertake positive net
present value projects. This natural hedging instrument works as insurance
when unexpected growth opportunities arise and insufficient funds exists.
Naturally, cash balances may also allow companies to prevent bankruptcy and
distress. These are the primary reasons why cash holdings are an important
source of financial flexibility. Important for this study, as it further examines the
implicationsof financial crises, is that Ang and Semedema (2011) find that firms
increase their cash holdings when a future recession is expected.
In conclusion with the above, financial literature shows that, in regards to cash
holdings, there are inconsistent beliefs about the level of these holdings in
conclusion by Denis (2011) and that there are both advantages and
disadvantages related to cash holdings.
2.3.2 Capital structure and debt
In correspondence with the findings by Graham and Harvey (2001) that suggests
that financial flexibility is the single most important determinant of capital
structure, flexibility can accordingly be obtained through a firm's capital
structure policy. By preserving access to low-cost sources of external capital,
firms are able to achieve a flexible capital structure, which in turn preserves
financial flexibility (e.g. Byoun (2007), Graham (2000)).
In traditional trade-off theory the optimal amount of external capital in a firm’s
capital structure is determined by the costs and benefits of leverage. Hence, the
optimal capital structure for a firm is a trade-off between distress costs, linked to
holding an excess amount of debt, and the tax-shield benefit. Assuming that a
firm’s leverage ratio is constant in a long-term perspective, trade-off models
thereby imply mean reversion, i.e. that temporary ex post deviations from long
run targets should be rebalanced over time. However, empirical research has
shown that firms observed debt ratios differ significantly from theoretically
predicted leverage ratios and that firms carry less debt than trade-off models
suggests (e.g. Fama and French (2001)).
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Examining the Sources of Financial Flexibility
In the paper by DeAngelo and DeAngelo (2007), the authors argue that financial
flexibility plays an important role in capital structure choices. By optimally
maintaining low levels of leverage in most periods, firms should be able to
preserve debt capacity in periods of high capital needs, e.g. to finance future
investments or growth opportunities. This concept is further developed in
DeAngelo et al. (2011) where firms create financial flexibility when facing
volatility in both cash flows and the investment opportunity set in order to avoid
costly underinvestment. Consistent with this view Byoun (2007) and Goldstein
et al. (2001) argue that the utilization of the option to borrow, i.e. the debt
capacity, make firms more vulnerable against future investment distortions. A
similar result is found by Lemmon and Zender (2010) when testing the peckingorder theory. Lemmon and Zender (2010) argue that equity issuers are
prevented from issuing debt based on the concerns over financial slack for future
investment and/or financial distress. This view is consistent with the findings of
Byoun (2008) that shows that “the external financing hierarchy suggested by the
pecking-order theory is reversed for developing firms due to concern for
financial flexibility”.
The optimal financial policy can, based on the above, be said to consist of low,
long run leverage targets that preserve debt capacity, taking in consideration the
cost of stockpiling cash due to agency and tax costs (DeAngelo et al. (2011)). By
splitting up the debt into two separate parts, as in the paper by Marchica and
Mura (2010), where a firm’s leverage ratio consists of both permanent and
transitory components, DeAngelo et al. (2011) show that the permanent
component is the firm’s long run target whereas transitory debt issues are an
important source of financial flexibility. Accordingly, a firm pro-actively respond
to shocks to its investment opportunity set and its cash flows, by subsequent
debt issues and/or repurchases.
The view that unused debt capacity is a source of financial flexibility is further
supported by Denis and McKeon (2011). The authors focus their data sample on
cases in which firms intentionally increase leverage beyond estimated long-run
targets by the use of substantial new borrowings. Studying the motives behind
the debt issues, Denis and McKeon (2011) find that these issues are primarily a
17
Examining the Sources of Financial Flexibility
response to operating needs, and thereby based on a firm’s opportunity set and
its flow of earnings. The main motives for the use of debt are (in the following
order of precedence); investments, increases in net working capital (primarily
increases in accounts receivable and inventory), cover reductions in operating
profitability and pay-out to shareholders. The findings in the same paper suggest
that sample firms reduce their leverage towards estimated but that this mainly
depends on a firm’s ability to produce a financial surplus. In case of firms
generating subsequent deficits, it is shown that these firms tend to cover these
deficits predominantly with more debt, regardless of target level leverage ratios
(Denis and McKeon (2011)).
Along with Denis and McKeon (2011) and DeAngelo et al. (2011), other recent
studies argue that transitory debt sources, such as commercial paper and lines of
credit, are common sources of financial flexibility. In the paper by Sufi (2009),
findings suggests that the firms has significant portions of unused lines of credit,
on average twice as large as the line of credit capacity that has been utilized.
Correspondingly, Lins et al. (2010) conclude that lines of credit are the dominant
source of liquidity and also a hedge against future financing frictions, which in
turn might hinder firms' ability to invest in the future. In Kahl et al. (2008), the
authors show that commercial paper provides financial flexibility to firms with
uncertain projections and funding needs. Further studies suggest that that the
level of uncertainty about future development is negatively correlated with the
firm’s debt ratio (Chung (1993) and Jinlong et al. (2009)).
Regarding the specific characteristics and level of debt Childs et al. (2005) show
in their results that a firm “optimally chooses short-term debt when it has future
financial flexibility and that agency costs can be driven to zero in such a setting".
The findings by Childs et al. (2005) also partly contradict the predictions by
Leland (1998), Goldstein et al. (2001) and Titman and Tsyplakov (2007) that a
financially flexible firm always choose a lower initial debt level. Instead Childs et
al. (2005) concludes that this depends on a firm’s asset structure and investment
opportunities.
18
Examining the Sources of Financial Flexibility
2.3.3 Flexible equity payouts and other financial policies
Another way for firms to affect or obtain their financial flexibility is through
corporate pay-out policy. A firm is primarily faced with two options in the case of
producing cash flows in excess of its current investment needs: stockpiling cash
for future needs or paying out the excess cash flows to shareholders.
Accordingly, a firm facing financing frictions in forms of high costs of external
finance and/or high volatility in its investment opportunity set, tend to adopt a
policy of low equity pay-outs (Almeida et al. (2004)). Hence, in the concept of
financial flexibility, the findings by Almeida et al. (2004) support the view that
flexibility affects the level of pay-out. Hypothesis states that dividend initiations
signal lower agency costs (Rozeff (1982), Easterbrook (1984), Jensen (1986))
and is perceived as a signal of higher expected future cash flow/profitability for
initiating firms (Officer (2011)). Thus, the incentive to save a higher proportion
of cash flows as cash, instead of paying out the cash flow to shareholders, vary
based on the characteristics of firms and their exposure to financing frictions and
need for financial slack. Agency costs of cash accumulation are according to
theory higher for firms with relatively poor investment opportunities and a
value-maximizing pay-out policy for such a firm involves higher pay-out levels.
In a model based in this prediction, the measures of the value of the firm's
growth opportunities are to be negatively associated with dividends (Fama and
French (2001), Denis and Osobov (2008), DeAngelo et al. (2006)).
Correspondingly to the above, firms tend to be reluctant to cut stated dividends
since such action could be perceived as a negative signal by the market according
to the findings of Blau and Fuller (2008). A potentially more flexible alternative
is share repurchases, since it can be adjusted “depending on whether current
cash flows represent permanent earnings or whether the current earnings
stream is likely to be non-recurring” (Denis (2011)). By not raising dividends
and instead use share repurchases in situations of cash-flows in excess to current
investment needs, firms thus avoids future dividend constraints and thus
increase the mean level of cash available for investment (Brav et al. (2005),
Daniel et al. (2011)). The findings by Jaggannathan et al. (2000) suggests that
firms that uses repurchases as the chosen form of pay-out tend to have more
19
Examining the Sources of Financial Flexibility
volatile cash flows and higher non-operating cash flows than firms using
dividends for distributing cash. This in turn suggests that firms with uncertain
cash flows are more likely to use repurchases if this uncertainty increases the
likelihood of frictions associated with raising external capital (Jaggannathan et al.
(2000), Lie (2005)). The findings by Jaggannathan et al. (2000) are extended by
Bonaime et al. (2012), to however a firm’s chosen form of pay-out is affected by
its risk management policies. Their findings suggests that pay-out flexibility
offers operational hedging benefits and that the extent to which a firm uses
hedging in their risk management affects both a firm’s level and form of pay-out.
Accordingly, flexibility considerations are likely to affect, not only the level, but
also the form of pay-outs. Recent findings by Fama and French (2001) present
evidence that firms, regardless of firm characteristics, has become less likely to
pay dividends. The authors suggests that the perceived benefits of dividends
have declined through time and that there has been an increasing tilt of publicly
traded firms towards characteristics such as small size, low earnings and nondividend paying.
Lastly, an alternative source of financial flexibility besides cash holdings,
corporate structure policies and corporate pay-out policies, are the sale of assets.
Assets sales can, according to theory, cover cash shortfalls that otherwise may
result in investment and dividend cuts. However, due to asset illiquidity, this
option can be excessively expensive (Shleifer and Vishny (1992); Pulvino (1998),
Daniel et al. (2011)).
2.4 Significance of financial flexibility and economic crises
Risk management have received greater interest since the last global recession
2007-2011 took place, resulting in lowered willingness to take on risk by banks
and the upcoming Basel III requirements. The crises led to increased difficulties
in attaining funds in external capital markets and firms had to forego profitable
investment opportunities that arose. During the sample period used in this
thesis, 1995-2011, several documented financial crises have occurred, e.g. the
Asian financial crisis (1997-1998), the Russian financial crisis (1998), bursting of
the dotcom bubble (2001) and the financial crisis (2007-2011).
20
Examining the Sources of Financial Flexibility
Campello et al. (2009) finds, specifically in the recent crisis, that firms invest in
profitable investment opportunities depending on the ability to raise external
funds in the capital markets. The supply of external finance declined during the
recent recession, which led to poorer company performance and lower
profitability growth rates. Duchin et al. (2010) further finds that this effect is
greatest for firms with low cash holdings or high net short-term debt. This is also
found for firms that are constrained. With sources attaining financial flexibility,
firms tend to avoid the dependence of external finance, especially crucial in
crises, which limit the access to these markets. This enables firms to use their
flexibility in order to invest in profitable opportunities. Marchica and Mura
(2010) further finds that financially flexible firms are not only able to invest, but
actually invests better, outperforms the market and highlights financial flexibility
as a value-enhancing policy. Gamba and Triantis (2008) supports these findings
as they claim that firms that are financially flexible should be valued at a
premium over less flexible firms. The linkage between financial flexibility and
financial crises can with the above said, is further studied in the following
sections.
21
Examining the Sources of Financial Flexibility
3 Sample description and methodology
This third chapter presents a description of the methodology used in this research.
The data sample is presented along with possible corrections for problems in order
to make the study valid and reliable.
3.1 Data
All accounting data is obtained from Datastream and historical weighting of the
OMXS30 index from NASDAQ OMX, representing the 30 most traded equities.
Appendix, Table 1 provides information about the OMXS30 composition from
1995-2011. The main reason for the choice of the OMXS30 is because the most
traded companies on a stock exchange during a longer period of time are more
likely to be mature firms with the important characteristic of paying dividends
which is an important element for the cash shortfall calculations used in this
thesis. The choice to limit the data sample to the index is also a reflection to the
findings in Denis and Osobov (2008) where the authors find that the
composition of the population of firms across countries have in the last decade
tilted towards a greater representation of firms with characteristics typical of
non-payers.
In the data retrieved, some financial items are given in local currency requiring
the conversion into SEK using the yearly average conversion rate during that
specific year.
3.1.1 Sample and excluded observations
The OMXS30 comprises the sample in this study, during the period 1995 – 2011.
Data prior to 1995 was incomplete in Datastream and thus limits the number of
observations used in this thesis to in total 349 observations. However, the
sample of 17 years is larger than the sample used by Daniel et al. (2011) where
15 years of data are collected, meanwhile the authors data sample ranges to 18
318 observations during the period 1992 – 2006.
Financial institutions as well as partly and wholly state owned firms are
excluded from the data sample due to the fact the financial policies differ from
22
Examining the Sources of Financial Flexibility
those considered industrials and others. For firm-years that have missing values
in certain items necessary for the calculation of shortfalls and how these are
resolved, e.g. net cash flow from operating activities, leverage, capital
expenditure etc., are excluded from the data sample. This gives a total number of
311 observations, below noted firm-years.
Denoting that there may be an effect of outliers, these observations are not
removed from the sample, however, these are tested for specifically in the
calculations to determine whether they may impact the results or not. This is
performed by sorting the shortfalls into quintiles on the basis of the size of
shortfalls/surpluses and performing calculations specifically for the groups.
Further noted is that the sample period covers periods of economic instability,
which implies outliers. The graph below shows the possible outliers of the
shortfall calculations.
Graph 1 Cash shortfalls
40000
Shortfalls (MSEK)
20000
0
0
50
100
150
200
250
300
350
-20000
-40000
-60000
-80000
Observations
3.2 Research approach
In the study by Daniel et al. (2011), the sample comprised of the S&P1500 for the
period of 1992-2006 in calculating cash shortfalls and determining how the firms
respond to such a shortfall. In order to provide for full comparability in this
study, the same approach of calculating cash shortfalls is used. However, this
time period extends from 1995-2011 and focuses on the OMXS30 index.
23
Examining the Sources of Financial Flexibility
3.3 Calculating cash shortfalls
Cash shortfalls are recognized when there is insufficient cash flow to cover for
the firm’s needs to pay dividends and continuing making investments at a
specific firm-year. The variables needed to calculate cash shortfall are given in
the following sub-section.
3.3.1 Input variables
Estimation of firms’ cash shortfall is given by the following notation:
Shortfall = expected investment + expected dividends – available cash flow > 0
where expected dividends equals last year’s dividends in consistence with e.g
Healy and Palepu (1990), DeAngelo and DeAngelo (1990) in Daniel et al. (2011).
Available cash flow is defined as cash flow available for dividends and
investment. Daniel et al. (2011) argues that because R&D expense is deducted as
a pre-tax expense in the income statement, the after-tax R&D expense is added
back to the operating cash flow. The formula is therefore:
𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 = 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 + 𝑅&𝐷(1 − 𝑡) − 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
where t equals the domestic company tax rate. In Daniel et al. (2011) the
effective tax rate is instead used, estimated as the ratio of total taxes paid to pretax income. Due to insufficient data this is not feasible in this study.
Expected investment, is defined as CAPEX + R&D(1-t). As in Daniel et al. (2011)
the post-tax value of R&D is used because R&D is expensed in the income
statement, and CAPEX is not. Missing values of R&D are given the value zero.
Daniel et al. (2011) estimates CAPEX as the median ratio of CAPEX/lagged assets
of the firm’s industry (2-digit SIC) multiplied by the firm’s lagged assets.
However, as this study comprises the OMXS30, the industries are limited in size.
Therefore, the data sample median is used instead of the industry median. R&D
is estimated the same way.
Daniel et al. (2011) explores the possibility if the expected investment may
provide bias results, leading to incorrect shortfall values. This possible
misspecification is tested by the use of three different definitions of expected
24
Examining the Sources of Financial Flexibility
investment. The study finds that despite using different definitions of expected
investments, the results are similar regarding number of shortfall years vs.
surplus years.
Pay-out ratios were not retrievable for all firms from Datastream, hence for these
firms, the ratios are computed manually. This was also the case for calculating
the CAPEX/lagged assets and R&D/lagged assets. The company tax rate for each
year was retrieved from Bolagsverket’s official webpage.
Initially the available cash flow for each firm-year, continuing with expected
CAPEX and R&D, expected investments and dividends is calculated to determine
a shortfall or surplus. If the value is positive, the firm-year is recognised as a
shortfall year. If it is negative, it is a surplus firm-year.
Recognizing that share repurchases is a part of management to distribute wealth
to shareholders, similar to paying dividends but an alternative method with tax
benefits, this should be factored in the model for determining shortfalls. For that
reason, expected share repurchases is added to the formula to see if there is any
significant effect on the number and average size of shortfalls/surpluses. The
formula is therefore extended to:
Shortfall = expected investment + expected dividends + expected share repurchases –
available cash flow > 0
where expected share repurchases equal last year’s share repurchases. This
assumption is supported by the observation that share-repurchasing firms in the
data sample seem to perform this action on cyclical basis. If values for share
repurchases are missing they are set to zero.
3.4 Model for resolving cash shortfalls
A dividend-paying firm faced with cash shortfall is faced with multiple options.
In this section, the choice of model is presented and followed by a description on
how to examine of how firms resolve cash shortfalls.
3.4.1 Choice of model
As stated earlier, the method used in this thesis follows one presented by Daniel
et al. (2011). In the framework set up by Daniel et al. (2011), a firm that is faced
25
Examining the Sources of Financial Flexibility
with cash shortfall must use one of the following options to resolve the shortage
in necessary funds: cut investment, cut dividends, reduce its cash balance, sell
assets, or raise funds in capital markets. A dividend paying firm is regarded a
Payer if in a given year if the firm paid cash dividends in the prior year. Dividends
in turn are defined as annual cash dividends. The model specification is the
following:
Shortfall = Investment Cutback + Dividend Cutback + Non-operating Cash +
External Cash + Cash Drawdown
3.4.2 Variables
Investment cutback, as one of the five explanatory variables, is measured as the
difference between expected and actual investment at the year of the observed
shortfall where Investment
t
= CAPEXt + R&Dt x (1-T). As noted earlier, the
expected CAPEX is equal to the sample median ratio of CAPEX/lagged assets
multiplied by the firm’s lagged assets. The same method is applied for expected
R&D and henceforth expected investment can be estimated as:
E(Investmentt) = E(CAPEXt) + E(R&Dt) x (1-T)
Investment cutback is thereby estimated as: E(Investmentt) – Investmentt
Dividend history is missing prior to 1995 for the selected sample in Datastream
and therefore it is not feasible to calculate dividend growth rates and apply these
rates for future assumptions regarding expected dividends. With respect to this,
expected dividend will equal the annual cash dividend paid in the prior year. The
same approach applied by Daniel et al. (2011) that find that in their sample firms
maintain dividends per share at the prior year’s level in a major proportion of
the firm-years. Accordingly, a dividend cutback is the difference between the
expected dividends and the current year’s dividends:
E(Dividendt) – Dividendt , where E(Dividendt) = Dividend t-1
The third variable is the possible reduction in cash or so called cash drawdown,
which is measured as the difference in a firm’s cash and short-term investments
in year t-1 and year t, in which the latter is when the cash shortfall occurs.
Including an exchange rate effect the variable are estimated as follows:
26
Examining the Sources of Financial Flexibility
Exchange rate effect = ΔCash & cash equivalentst + ΔShort-term Investmentst +
ΔExchange rate effectt
where the change in cash and cash equivalents are calculated as:
ΔCash & cash equivalentst = ΔOperating activitiest + ΔInvesting activitiest +
ΔFinancing activitiest + ΔExchange rate effectt
To measure in what extent firms cover shortfalls by raising funds in the capital
market, the variable external cash is calculated from the firms’ statement of cash
flows. The variable is estimated as the net cash flow from financing activities,
including the issuance and retirement of stock and debt.
Non-operating cash is measured as the net cash flow from investing activities, but
does not include CAPEX and change in short-term investments. Non-operating
cash as a variable in the model represents asset sales, i.e. sales of property, plant,
and equipment and the sale of investments in affiliates.
3.4.3 Determinants of financial flexibility
According to Daniel et al. (2011) the average value of each of the variables in the
data sample should be estimated, this is in order to estimate what percentage of
the average shortfall that is financed by each of the five sources. The average
value is divided by the sum of the average value of all sources, instead of the
shortfall. Accordingly, this will lead to that the percentages add up to hundred
and a positive estimated number could thereby be interpreted as a source of
cash for the firm. Inversely, a negative % should be interpreted as a use of cash.
In order to examine however the results possibly driven by firms that have large
cutbacks as a result of large shortfalls, the sample data is sorted into quintiles on
the basis of the size of the shortfall and surplus respectively. This procedure is
then applied on the sub-samples consisting of payers and non-payers, and
results are presented in the same table as above.
To check if the investments are due to or significantly affected by unobservable
factors “that are correlated with a firm-specific decline in the profitability of
growth opportunities” (Daniel et al. (2011)) a replication of the test above is
performed. In the replication, it is assumed the following for each firm:
27
Examining the Sources of Financial Flexibility
Investmentt = E(Investmentt) ⇔ E(Investmentt) – Investmentt = 0
i.e. that the level of investment is equal to its actual investment, hence the
investment cutback is zero for each firm. Moreover, an analysis based on this
assumption will show how firms cover shortfalls via dividend reductions,
external financing, asset sales, and cash reductions.
Recognizing the importance of external financing as a source of funds to cover
shortfalls (Denis and McKeon (2011), DeAngelo et al. (2011)), Daniel et al.
(2011) perform an additional test reporting the two primary components of
external financing, namely net cash from equity (ΔCFE) and net cash from debt
(ΔCFD) along with external cash miscellaneous. Net cash from equity, is the net
cash from issue and repurchase of stock. The notation for the measure is the
following:
ΔCFE = Issure − Repurchase
Given the limitations in the data sample, net cash from debt representing the net
cash from issuance and retirement of debt, and external cash misc. is conjoined
in a single measure. The components of external cash misc. are according to
Daniel et al. (2011):
External cash misc. = Cash flow from other financing activities – (Cash dividends
– preferred dividends - common dividends)
which equals the net cash from sale of miscellaneous financing activities. By
estimating the average values the two measures mentioned above across the
data sample the preferred source of external finance can be shown. This is
conducted for firms with shortfalls and surpluses separately, further forming
sub-groups of payers and non-payers. As in previous sections, a positive average
measure represents the increase of funds and thereby the issuance of equity or
debt respectively (noting that income from other misc. financing activities affect
the measure of net debt). Correspondingly, a negative measure denotes a
repurchase of the same and thereby a decrease of funds. As in the tests
performed earlier, a replication of the test is performed on a sub-sample
consisting of the firms with the largest shortfalls/surpluses to examine however
firms with large shortfalls/surpluses drive the results.
28
Examining the Sources of Financial Flexibility
Finally the change in firms’ leverage ratio, estimated as the ratio of change in
total debt scaled by lagged assets is calculated.
3.5 Cross-sectional determinants of resolving cash shortfalls
In this section, the previous tests of how firms resolve their shortfalls is further
developed by examining how various measures of financial flexibility and other
firm characteristics impact such choices and thus heterogeneity in average
findings is resolved. Based on the median value of each characteristic, firms are
sorted into equal-sized groups. The magnitude of the shortfall and how it is
covered by each source of fund is then estimated, following the same method as
in the previous section.
3.5.1 Measuring financial flexibility
In the model proposed by Daniel et al. (2011) five different measures of financial
flexibility is considered: excess leverage as the lagged ratio of debt-to-assets in
excess of the median firm, excess cash holdings as the lagged ratio of cash-toassets in excess of the median industry firm, Altman’s Z-score according to
Altman (1968), and the ratio of short-term debt to total debt. A possible
alternative measure of excess cash holdings commonly used in literature is a two
step process used in e.g. Bates et al. (2009), Dittmar and Marht-Smith (2007) and
Opler et al. (1999). It is also feasible to use target leverage instead of excess
leverage in the model following the procedure by Frank and Goyal (2009),
however both of these alternative measures are not used in this thesis. As noted
above, the median values of the proxies above separate the sample firms into
two groups (High and Low) that respectively are tested on how they cover
shortfalls.
Based on the firm’s rank along the flexibility measures, in addition to the
individual measures of flexibility an overall flexibility score is also produced. The
score is depends whether a firm has a value for the flexibility proxy variable that
is above or below median, resulting in a score of 1 or 2 respectively for each data
sample observation. This is performed for all proxies of flexibility. The firm’s
flexibility scores is then summed up, together forming an aggregate flexibility
score for that firm. Ranging from a minimum of 4, which signals poor financial
29
Examining the Sources of Financial Flexibility
flexibility, to a maximum value of eight, which signals high flexibility, these
scores serve as separators when creating groups depending on level of financial
flexibility. These groups are subsequently tested individually as above. It is being
assumed that firms exhibiting low excess leverage have more debt capacity, thus
leaving higher financial flexibility, as cutting investments or dividends would not
be compulsory to cover for shortfalls. It is further assumed that firms with high
excess cash holdings are less likely to cut or reduce dividends and investments as
well, because they are more likely to draw down on the cash balances instead.
Low short-term debt to total debt and high z-score also aids to higher flexibility,
as they are assumed to be more likely to be able to conduct external financing.
Below is a demonstration of calculating the score for the most flexible firm:
Excess leverage
1 for above median, 2 for below median
Excess cash
2 for above median, 1 for below median
Altman Z
2 for above median, 1 for below median
Short-term debt
1 for above median, 2 for below median
Hence, the most flexible firm would receive a total of 8. The opposite would
occur for the least flexible firm. This is only a relative measure based on the
assumptions above.
3.5.2 Other firm characteristics and determinants
The procedure performed for the proxies of financial flexibility is replicated
using other determinants of how firms resolve cash shortfalls. Specifically, four
individual proxies are examined; a measure of whether or not the cash flow
shock leading to the shortfall is long-lived, the role of growth opportunities, payout ratio, and whether or not the cash shortfall occurred during a period
characterized by high financing frictions and growth opportunities, i.e. financial
crises.
A firm is defined as having a “long-lived” cash flow shock in the case it is
estimated to have a shortfall in three continuous years, as counted from the
30
Examining the Sources of Financial Flexibility
current year. The proxy for growth opportunities is estimated as the ratio of the
firm’s market value to its the book-value of its assets, calculated as follows:
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
Based on the lagged value of the ratio, groups are formed using the median value.
As the firms’ investment opportunity set increases in value, the firm will tend to
borrow less at current (Smith and Watts (1992)). The intuition by these findings
are that, growth options represent intangible assets and that the issue of debt
today is associated with a higher level of uncertainty that would restrict the
firms’ ability to invest in the future. In order to effectively capture a firm’s
dividend policy the dividend pay-out ratio is added as a proxy.
The last proxy in additional to the above, is the dummy variable for high financial
growth and recession, below noted financial crisis. Based on that the sample
period ranges from 1995-2011, sub-periods are created where observations of
shortfalls within the periods characterized by financial crises are separated into
one group and the other into another, see Graph 2 and Graph 3 for comparison in
appendix. Since the data sample is based on the Swedish market the following
periods should be chosen: 1998-2002 comprising the inflation and bursting of
the dot-com bubble and the Asian/Russian financial crises, and the period 20072011 that represent the recent financial crises.
3.6 Hypothesis
The following six hypotheses are made before conducting the study.
Hypothesis 1: Firms with higher financial flexibility are less likely to cut
investment and will more likely tend to cover shortfalls with internal or external
sources of funds.
Hypothesis 2: It is assumed that firms with low estimated excess leverage are
more likely to have spare debt capacity and are therefore more likely to fund
shortfalls with external funds than extensive investment cutbacks. Similar
assumption with high excess cash holdings is made.
31
Examining the Sources of Financial Flexibility
Hypothesis 3: Firms with more short-term debt relative to total debt and with a
lower z-score have less flexibility to cover the shortfall through external
financing and are thereby more likely to use internal funds or cutbacks.
Hypothesis 4: Firms with high growth opportunities are less likely to cut
investment and instead more likely to be covering the shortfall with external
finance and dividend cuts.
Hypothesis 5: In consistency with DeAngelo and DeAngelo (1990) and DeAngelo
and DeAngelo (2007), the conjecture is that dividend-paying firms are less likely
to cut dividends to finance cash shortfalls due to that firms with higher dividend
payout ratios have investors, which are particular about maintaining the
dividend level.
Hypothesis 6: Treating dividends as a residual and investment policy as of firstorder importance, firms’ facing shortfalls during financial crises, e.g. liquidity
crunches are more likely to cut dividends and sell assets since crises can be seen
as a credit crunch or exogenous shock.
3.7 Methodological Problems
This thesis is subject to some shortcomings, as it comprises of empirical tests
based on raw data from databases such as Datastream. This raw data has then
been edited and processed in Microsoft Excel, which itself contains limitations
when working with large data. Validity and reliability below are also topics
raised in terms of methodological problems.
3.6.1 Validity
In order for this study to be valid, the study with its results must justify the
conclusions drawn. The method used in this study is untested and has only been
used once by Daniel et al. (2011). Hence, it may not cover all significant sources
that firms may use to cover shortfalls. The used variables in calculating shortfalls
have been applied by Daniel et al. (2011), and for that reason it is deemed to be
valid. Although the use of share repurchases as a factor in calculating shortfalls
have never been used previously, it is believed to be valid as well. Yearly
reported firm data has been used for all variables in our analyses, and are
32
Examining the Sources of Financial Flexibility
retrieved from Datastream database. Values from Datastream are considered
valid. Since the dividend paying firm-years that exhibit shortfalls have been
sorted by having a high or low Altman Z-score to determine how these firms
resolve the shortfalls, this measure needs to be scrutinized as well. Altman Zscore is based on historical financial data, which does not imply anything about
future circumstances (Pike and Neale (2003)). Beside this, accounting policies
practised by these firms involve delays before becoming official, which in turn
aids to incorrect inferences about the current financial state of the firms. There is
also a lack of conceptual base in the Z-score, as there is not enough information
to draw any conclusions about the time scale of failure (O’Regan (2002)).
In the data retrieved, some financial items are given in local currency requiring
the conversion into SEK using the yearly average conversion rate during that
specific year. The exchange rate may vary slightly depending on which sources
that are being used.
3.6.2 Reliability
It is also essential that this study provides reliable results, in combination with
being valid. The collected data stems from Datastream, and it is from here the
ratios are derived. This data, together with the used methods, need to be
examined to the extent it can be claimed that the results generated are reliable.
Datastream can be considered as reliable. As this study has not excluded
acquisitions from non-operating cash, our ratios may be reliable to a lesser
extent than if they would have been taken into consideration. The issue also lies
at the fact that the results cannot be generalized as our sample only extends to
the 30 most traded firms. Therefore, it might not be applicable to smaller firms.
Another point is that our sample time period extends from 1995-2011, a period
which is heavily characterized by high growth and financial instability. For that
reason, results may differ depending on the choice of time period, when for
example, financial crises are less apparent. In some cases, firms might “follow the
leader” in the sense that the behaviour of one firm may influence the behaviour
of the other. A trend could appear, such as having a high pay-out ratio or having
high excess leverage, which is mostly a temporary behaviour.
33
Examining the Sources of Financial Flexibility
4 Empirical findings
In this chapter the empirical findings are presented and compared to previous
conducted studies. The results cover cash shortfall estimations and the sources used
to resolve these.
4.1 Shortfalls
The sample index median ratio of CAPEX/Lagged assets is 0,048 and 0,019 for
R&D/lagged assets. By using this ratio to retrieve expected CAPEX and R&D
which in turn gives expected investments, a positive or negative shortfall is
presented for each firm-year.
Below follows a short explanation of how to interpret the following tables.
Negative value implies
Positive value implies
Shortfall
Surplus
Shortfall
Dividend Cutback
Increase dividends
Decrease dividends
Investment Cutback
Increase investments
Decrease investments
External Cash
Retire debt
Issuance of debt
Non-operating Cash
Investments in assets
Asset sales
Cash drawdown
Increase cash balances
Decrease cash balances
Table 2 reports that 69 firm-years, or over 20 %, in the sample are cash shortfall
years. Consistent with Daniel et al. (2011), there are 5 737 firm-years,
corresponding to 31 %, that are shortfalls. The average value of the shortfall
among the firm-years is 2 471 MSEK. The shortfalls are similar between those
firms who are payers and those who are not (2 426 MSEK versus 2 943 MSEK).
Daniel et al. (2011) receives an average of $96 MUSD for the shortfall, which
corresponds to approximately 687 MSEK (fxtop.com), a lower value than
calculated by this study. One reason to why the average shortfall amount of 2
471 MSEK is considerably different from the value retrieved in Daniel et al.
(2011).
34
Examining the Sources of Financial Flexibility
Table 2
N (firmyears)
Expected
Investment
(MSEK)
Expected
Dividend
(MSEK)
Available
Cash Flow
(MSEK)
Shortfall
(MSEK)
Change in
expected
investment
Change in
Available
Cash Flow
All firms
69
4963
1903
4395
2471
268
-1750
Payers
63
4899
2084
4557
2426
338
-1973
Non-Payers
6
5640
0
2698
2943
-450
517
All firms
242
5553
3124
16989
-8312
293
1125
Payers
224
5716
3375
17808
-8717
331
1194
Non-Payers
18
3533
0
6806
-3273
-279
574
Total
311
Shortfall > 0
Shortfall (surplus) ≤ 0
The majority of the shortfall firm-years in the findings were dividend-paying
firms, whereas it is almost equally divided between payers and non-payers
according to results by Daniel et al. (2011).
242 firm-years (nearly 80 %) are characterized by surplus years. The majority of
firm-years (non-payers and payers) are surplus years. The average surplus value
for payers is 8 717 MSEK which is larger than for non-payers. The proportion of
non-payer surplus firm-years to payer surplus firm-years does not significantly
differ from the respective proportion among non-payer shortfall firm-years to
payer shortfall firm-years (7 % vs. 9 %, respectively but not reported in the
table). The change in expected investments is below zero only for non-payers
whether it is a shortfall or surplus year (column 7, row 3 and 6 in Table 2).
Additional information is given in Table 3, which is presenting in-depth results
from positive shortfall firm-years, showing the magnitude of the shortfalls. Table
3 shows how much the shortfall is in percentage to expected investment,
expected dividend and prior year’s cash level. It also gives a perspective on how
many firms in percentage that would be able to cover the shortfall by eliminating
expected investments, dividends or cash balances completely. Although this is
only for theoretical use, it is a good measure of the degree of shortfall. For all
firms, the positive shortfall represents 50 % of expected investment, 130 % of
expected dividends and 40 % of the firm’s prior year cash balance. In terms of
expected investment, this is in line with Daniel et al. (2011) results where
shortfall represents 41 % of expected investment. Nonetheless, for expected
35
Examining the Sources of Financial Flexibility
dividends and prior year cash balance the numbers are different at 252 % and 57
% in their study.
Further the results report that, for payers, 77 % of the firms could cover the
shortfall by eliminating investment completely, 59 % by cutting dividends, 77 %
with available cash and 86 % by a combination of cash and dividends. These
findings suggest that in regards the shortfall sample firm-years in Daniel et al.
(2011), firms are able to cover the shortfall with a similar proportion by
eliminating investment completely (79 %) and to a less extent by cutting
dividends (28 %), by cash (50 %) and as a combination of cash and dividends
(63 %).
Table 3 A Closer Look At Firms with Positive Shortfalls
Shortfall
Expected
Investment
Expected
Dividend
Available Cash
Flow (Ct-1)*
Ct-1 + Expected
dividend*
All firms (N=69)
Level
2471
4963
1903
6251
8200
Shortfall as a % of level
NA
50%
130%
40%
30%
% of firms that could fund 100% of shortfall
NA
77%
59%
77%
86%
Payers (N=63)
Level
2426
4899
2084
6651
8792
Shortfall as a % of level
NA
50%
116%
36%
28%
% of firms that could fund 100% of shortfall
NA
76%
56%
78%
87%
Non-Payers (N=6)
Level
2943
5640
0
2180
2180
Shortfall as a % of level
NA
52%
NA
135%
135%
% of firms that could fund 100% of shortfall
NA
83%
0%
67%
67%
In Table 3, it shows that approximately 86 % could be covered with a
combination of cash and expected dividends. This percentage is high considering
the fact that the companies would not need to cut investments at all, or raises
additional funds through equity issuance or asset sales. This number is only 63
% for the study in Daniel et al. (2011). Shortfall represents 50 % of expected
investments and 40 % of prior year cash balance.
An additional factor is added to the model for calculating cash shortfalls, to
estimate a model that may give more accurate results, than the model proposed
in Daniel et al. (2011). This model accounts for share repurchases and provides
similar, but not identical, results in Table 4. Using this model, the amount of cash
shortfall firm-years are to some extent increased from 69 to 70 firm-years with
36
Examining the Sources of Financial Flexibility
an average shortfall amount of 2 940 MSEK. The average surplus amount is
considerably different at 6 406 MSEK.
With the repurchases column 5 is added to Table 4 showing that the average
expected repurchases are close to half than that of expected dividends for
shortfall firm-years (934 MSEK and 2 102 MSEK, respectively). For surplus firmyears, the average expected repurchases are significantly smaller than expected
dividends (1 817 MSEK and 3 071 MSEK, respectively).
Table 4
N
(firmyears)
Expected
Investment
(MSEK)
Expected
Dividend
(MSEK)
Expected
Repurchase
etc. (MSEK)
Available
Cash Flow
(MSEK)
Shortfall
(MSEK)
Change in
expected
investment
Change in
Available
Cash Flow
All firms
70
2006
2102
934
5273
2940
276
-1710
Payers
64
5133
2300
1022
5514
2940
346
-1926
Non-Payers
6
5640
0
0
2698
2943
-450
517
All firms
241
5494
3071
1817
16787
-6406
298
1126
Payers
223
5652
3318
1961
17593
-6661
331
1171
Non-Payers
18
3533
0
33
6806
-3241
-279
574
Total
311
Shortfall > 0
Shortfall ≤ 0
14 companies had solely surplus years and no shortfalls at all (without taking
repurchases into account), when listed on the OMXS30 (except for some
excluding years in the sample). This is in regards to both taking and not taking
into account share repurchases calculations. These firms were: Alfa Laval (20032011), Assa Abloy (2001-2011), Astra (1995-1998), Astra Zeneca (1999-2011),
Atlas Copco (1999-2011), Boliden (2006-2011), Europolitan (2001-2002),
Getinge (2009-2011), H&M (1998-2011), Lundin Petroleum (2008-2011), MTG
(2009-2011), Nokia (1997-2011), Scania (1997-1999 and 2007-2011), Sydkraft
(1995).
4.2 How firms resolve cash shortfalls
Table 5 in appendix shows how the sample firms resolve cash shortfalls. What is
observable is that paying firms with a shortfall cut dividends in by 441 MSEK.
Daniel et al. (2011) finds in contrast that paying firms, both facing a shortfall and
surplus, shows a slight increase of 1 MUSD. This implies that firms in the author’s
37
Examining the Sources of Financial Flexibility
data sample on average do not decrease dividends, whereas for the data sample
in this thesis, they do cut dividends significantly. If firms in the sample
experience a cash surplus year, dividends are increased by, on average, 545
MSEK. For Daniel et al. (2011) this value is an increase of 11 MUSD. Conversely,
paying shortfall firm-years in this sample, increase their investments by 411
MSEK (accounting for 9 % of the shortfall) and by 3711 MSEK if it is a surplus.
This implies that the firms in the paying shortfall case would not have to cut
dividends by 441 MSEK, would they not increase investments at this magnitude
(411 MSEK). To cover for the remaining shortfall, firms raise additional financing
of 1632 MSEK, covering for about 35 % of the shortfall. Asset sales cover for 152
% of the shortfall and a value of 7071 MSEK. This is particularly different from
Daniel et al. (2011) where the asset sales only represent 5 % of the shortfall and
a value of only 6 MUSD. However, in terms of cash balances, this is in line with
Daniel et al. (2011), i.e. both suggesting that paying firms in a shortfall year
actually increase their cash balances. For the sample in this study, the value is 4
091 MSEK (88 % of the payer shortfall) and for Daniel et al. (2011) 6 MUSD
covering for 6 %.
Table 5 also reports how many firms in percentage that raise money from a
particular source (row 3). 30 % of the paying firms cover the shortfall by cutting
dividends and 51 % uses external financing (similar to 59 % for Daniel et al.
(2011) who further finds that only 6 % in that sample cover shortfalls by cutting
dividends). It is recognized that 87 % of the payers covers the shortfall by asset
sales. Extending this study of resolving cash shortfalls, the dividend paying firms
are sorted depending on the size of the particular shortfall. The firms with the
largest shortfalls (average = 28 283 MSEK), are reported on row 4 in Table 5. For
The payers with the highest shortfall on average decrease their dividends,
increase investments, raise money from external funds, sell assets and increase
cash balances. These results are the same for the payers not included in the top
quintile. For the latter group of firms, the primary means are non-operating cash
(selling assets) and cash drawdown. However, for the top quintile external
financing and cash drawdown are the primary means of resolving the cash
38
Examining the Sources of Financial Flexibility
shortfall. This is not in line with the results from Daniel et al. (2011) where
investment reductions and external financing are the primary sources.
For payers with a surplus, the bottom quintile reports same primary sources as
for the total surplus average. Selling assets and increase of cash balances are the
two primary means. These firms also increase dividends and investments over
expected levels and repurchase debt and equity. For Daniel et al. (2011), the only
difference is that those firms invest in other assets rather than selling them. In
Table 5 it is shown that paying surplus firms use 171% of the surplus to increase
cash balances.
Table 5, panel B presents the results for non dividend paying firms and for
apparent reasons, dividends cannot be cut as they are non payers, but in the case
of a surplus, dividend initiation can occur. For the surplus, 16 % of the surplus
contributes to increase in (initiation of) dividends. For shortfall years, a small
percentage involves cutting investments and drawing down on cash. It is mostly
the sale of assets (80 %) that covers for the shortfall.
Studying the disaggregated analysis of external financing, it is reported in Table
6 that both shortfall and surplus firms (payers) on average use net cash from
debt along with cash flows from misc. financing to cover shortfalls, rather than
raising funds through equity. A significant result is that, on average, surplus
firms are more likely to increase their leverage ratio to a greater extent than
shortfall firms. As reported in the table, net debt issues are significantly larger
for firms in the quintile for firms having the largest shortfall, and these firms also
increase the firm’s debt ratio by 12 % on average. The results for non-payers are
significantly different, with larger repurchases and larger retirement of debt
than issuance of equity.
Table 6 Disaggregated analysis of external financing
Panel A: Payers
Shortfall (MSEK)
Shortfall > 0
Shortfall in the top
quintile (0,99)
Shortfall ≤ 0
Shortfall in the bottom
quintile
Net cash from equity
(MSEK)
Net cash from debt
and misc. (MSEK)
Change in leverage
2426
-92
1724
1%
28283
0
22542
12%
-8717
-1882
1023
3%
-67822
-7722
-1704
-1%
39
Examining the Sources of Financial Flexibility
Panel B: Non-Payers
Shortfall (MSEK)
Net cash from equity
(MSEK)
Net cash from debt
and misc. (MSEK)
Change in leverage
Shortfall > 0
2943
5671
-2122
2%
Shortfall in the top
quintile
11208
32840
-18796
-3%
-3273
52
-821
-2%
-8202
543
-809
-4%
Shortfall ≤ 0
Shortfall in the bottom
quintile
Also denoted is that the investment cuts in the non-paying shortfall firm-years
(2023 in Table 5, panel B) may not solely be due to the fact that it is a shortfall
year, but may also be because of unobservable factors like declines in the
profitability of growth opportunities. Table 7 in appendix reports the same
results as in Table 5 but assuming that expected investment equals actual
investment makes investment cutback equal to zero. In this case, asset sales are
still the largest factor covering for the shortfall for payers (183 %), in line with
the previous definition of expected investment in Table 5.
4.3 Financial flexibility and results from cross-sectional determinants of
resolving cash shortfalls
Panel A, Table 8 in appendix report that dividend paying firms covers a greater
percentage of the shortfall with external financing when they have high excess
leverage, lower Z-score, less short-term debt and low cash holdings. This result is
inconsistent to Daniel et al. (2011), where opposite results were generated
except in regards to the short-term debt.
The percentage of the shortfall covered by external finance is not strictly
monotonic in relation to the aggregate flexibility score. Firms with a score of 4
(least flexible) cover the shortfall with increases in leverage (on average 2 985
MSEK) and those with a score of 8 (most flexible) retires debt by on average
1 421 MSEK, inconsistent with Daniel et al. (2011). Firms with the lowest
flexibility increase investment by on average 778 MSEK, and highest flexibility by
135 MSEK. For firms with high flexibility they do not seem to cut dividends
significantly, consistent with Daniel et al. (2011). However, the results in Table 8
suggest that with low flexibility, cutting dividends is more common. Further it is
shown that firms in this sample cover their shortfalls more by selling assets if
they have high cash holdings than if they have low (11 302 MSEK vs. 3 462
MSEK).
40
Examining the Sources of Financial Flexibility
Firms with higher market-to-book ratio cover a higher percentage of the
shortfall with investment cutbacks than firms with lower market-to-book value.
Consistent with Daniel et al. (2011), firms with higher market-to-book ratio
cover a higher percentage of the shortfall with sale of assets than those with a
lower ratio (2 412 MSEK vs. 11 585 MSEK). Selling assets is also the most likely
way of covering shortfalls for high growth companies. Both low and high marketto-book ratio implies that companies decrease their dividends, and slightly more
for high growth companies. The results by Daniel et al. (2011) seem to be
consistent with the findings in this thesis with the exception that for the case of a
low market-to-book ratio firms leave dividends unchanged. As reported in Table
8, firms increase cash holdings both for high and low market-to-book.
The table also reports the amount of shortfalls that occurred during a financial
crisis. Almost 67 % (42/63) of all observations of cash shortfall firm-years
occurred during a financial crisis. A significant difference for observations of
cash shortfall firm-years that didn’t occur during a financial crisis is that these
firm-years increase dividends by an average of 118 MSEK.
It is shown that firms that exhibited ‘long-lived’ cash flow shocks are in greater
extent associated with higher dividend cutbacks, higher investment reductions
and higher levels cash generated from of asset sales. Firms with longer-lived
shocks increase their cash balance on average 553 million SEK whilst firms with
no longer-lived shocks on average increase cash balances with 4302 million SEK.
Studying the results from the determinant representing dividend history, results
suggest that firms with a higher pay-out ratio in less extent cut back on
dividends than those with a low pay-out ratio (on average 313 MSEK vs. 591
MSEK, respectively in Table 8). In line with this, high pay-out firms increase their
cash balance significantly in comparison with low pay-out firms that are shown
to instead decrease theirs slightly. The latter group of firms also increases
investments according to results whereas high pay-out firms according to the
conjecture made, use investment cutbacks to accumulate funds. Low pay-out
firms in larger extent use external cash and asset sales to cover shortfalls.
41
Examining the Sources of Financial Flexibility
In conclusion with the above, results suggests that there exist significant crosssectional differences in how firms resolve cash shortfalls.
5 Analysis
This chapter contains an extensive analysis of the hypothesis presented in section
3.6 with a short discussion based on the empirical results. The findings are related
to the previous finance literature presented in chapter 2.
5.1 The impact of financial flexibility on financial policy
On the one hand, the results in this study are in general consistent with previous
finance literature. On the other hand, this study reveals new findings. Table 9 in
appendix provides a comprehensive overview of the hypotheses in comparison
with the results. Perhaps would the results be more consistent with the findings
in Daniel et al. (2011) if the variety of firms would have been wider and a larger
sample size being used.
In contrast to earlier findings, this thesis present evidence that the primary
sources of financial flexibility in the face of significant cash flow shortfalls vary
across different determinants but that asset sales is the most frequently
occurring source for firms. It is therefore not possible to generalize in that
manner that firms primarily rely on certain sources but, based on certain
characteristics, findings support some views in corporate finance literature.
All of the firms in the sample are regular dividend payers (with only some
exemptions for particular years) and have been so throughout the sample period.
In the work made by Daniel et al. (2011), non-payers have not been excluded in
his sample of 1500 firms but allocated a value of zero for expected dividends.
This is also clearly visible in his results when expected dividends correspond to
roughly only a sixth of the value of expected investments, comparable to the
results in this study where expected dividends is nearly half of expected
investments. Intuitive to these studies is that available cash flow is much smaller
for firms with a shortfall. What is also consistent and similar to Daniel et al.
(2011) study is that the change in available cash flow is much larger than the
42
Examining the Sources of Financial Flexibility
change in expected investment, relative to the prior year. This suggests that the
shortfalls are most likely due to reductions in net cash flow from operating
activities, and in the surplus case, due to increases in this cash flow.
5.1.1 Hypothesis 1
The first hypothesis is that firms with higher financial flexibility are less likely to
cut investment and will more likely tend to cover shortfalls with internal or
external sources of funds. Partially consistent with the results, it is found that
firms are more likely to cover shortfalls with internal funds and secondly by
selling assets. This last finding is consistent with the hypothesis, but in terms of
cutting investment, firms with the highest flexibility are least likely to raise
additional financing and to cut investment. Firms are actually increasing
investment slightly, on average.
Cutting investments to cover for shortfalls is a very rarely common practice in
the results. It only occurs for the firms having high growth, high pay-out ratio or
in the presence of a long-lived shock, but never as a primary choice and actually
increase investment in the other scenarios (Table 6). Brown and Peterson (2011)
provide an explanation for this observation. The authors state three reasons for
this. Firstly, increasing R&D involves financing frictions due to limited collateral
value. R&D is therefore to be viewed as an illiquid asset and investment cutbacks
should therefore be non-profitable for raising funds. Furthermore, investments
in R&D have significantly increased and are currently the principal investment
for publicly traded U.S. firms (Brown and Peterson (2011)). With no current
data, this could possibly be the case for Swedish listed firms, explaining the
results. Secondly, because R&D is financed almost only with volatile sources of
finance such as cash flow. Lastly, there are many adjustment costs as it is
associated with salaries to highly skilled employees, including extensive training
and hiring costs.
The findings of Daniel et al. (2011), show that firms sell assets to cover for
shortfalls in order to avoid cutting dividends or investment. When investigating
this in Table 8, it can be stated that these findings are similar to the results in this
43
Examining the Sources of Financial Flexibility
thesis. For nearly every firm-year characterized by a shortfall covered by asset
sales leads to an increase in either investment or dividends.
5.1.2 Hypothesis 2
The second hypothesis assumes that firms with low estimated excess leverage
are more likely to have spare debt capacity and are therefore more likely to fund
shortfalls with external funds than extensive investment cutbacks. Similar
assumption with high excess cash holdings is made. On another note, results
show that firms with low estimated excess leverage are more likely to fund
shortfalls with selling assets, instead of drawing down on cash balances, which
actually increases. The same goes with high excess cash holdings.
In line with Daniel et al. (2011) an in contrast to models of optimal cash holdings,
the findings in this thesis suggests that firms facing liquidity crunch are less
likely to solve a shortfall by drawing down cash reserves. It can thereby be
concluded that cash holdings in times of liquidity shortages don’t serve as a
buffer, as optimal cash holdings imply. As recognized earlier, the only time that a
firm facing shortfall temporarily draws down these cash balances, is during
financial crises. Hence, there is no clear sign of avoidance of costly external
financing, except in times of large credit crunches when access the external
capital market is limited and the firms debt capacity is constrained. In what
extent the same importance of debt capacity, as a source of financial flexibility,
on the costs of external finance can be attributed is left unstated since findings
are not consistent.
Firms with shortfalls raise external funding (debt issuance) in most of the states,
except when the firm has low excess leverage they repurchase shares (or issue
debt, although less likely but not reported in the table) or high overall flexibility
score. This might imply that firms in the sample are less concerned about saving
debt capacity and benefits more from the tax advantages by raising debt. This
can be paralleled with the trade-off theory. Firms that use external funds to
cover for the shortfall are on average raising debt rather than equity (on average
1724 MSEK, Table 6). However, this might lead to inability for firms to raise
more debt in the future causing them to bypass attractive investment
44
Examining the Sources of Financial Flexibility
opportunities if and when they would arise, according to Campello et al. (2009).
The same tendency is observable for surplus firms.
The only situations when a firm is likely to be drawing down on cash balances is
when a firm has the highest flexibility score or in the second situation, when the
pay-out ratio is low.
In Daniel et al. (2011) the findings suggest external funds and more specifically
debt capacity, represents the primary source of financial flexibility. Unable to
confirm these results, the findings in this thesis however show that firms
experiencing subsequent financing surpluses are likely to use the funds
generated from the surplus to pay down debt.Hence the results in this thesis
cannot serve as an indicator of transitory role of debt.
Demonstrated in chapter 4, firms with low excess leverage tend to sell assets to
cover for the shortfall but meanwhile are likely to increase investments. In this
particular case, these firms will likely sell non-core assets when doing so, as
selling core assets to increase investments is counter-intuitive. However, selling
non-core assets is associated with a risk, as the cost of selling those assets
depends highly on the liquidity of the asset. Thus, illiquid assets bear a possibly
large transaction cost. If the assets are liquid and sold at a low cost, it could be
considered consistent with the pecking-order theory. Raising additional funds
may be perceived by the investor as a negative signal as it implies that a firm’s
cash position is weaker than expected (Miller and Rock (1985)). The advantage
of selling assets is that a firm may be able to disguise a financing need as one that
is business motivated, or, motivated as a desire to dispose a none-synergistic
asset. If the motive is unknown of the asset sale, market may perceive the asset
sale as less negative.
5.1.3 Hypothesis 3
The third hypothesis is that firms with more short-term debt relative to total
debt and with a lower z-score have less flexibility to cover the shortfall through
external financing and are thereby more likely to use internal funds or cutbacks.
The results show that firms with high short-term debt and a low z-score
45
Examining the Sources of Financial Flexibility
primarily sell assets and secondly external financing to cover for the shortfall,
and less by drawing down internal funds (cash balances).
Hypothesizing that firms’ facing shortfalls may not only cutback on funds but
also refrain from paying out funds, short-term debt is further analysed. A
measure used for determining in what extent firm depends on trade credit for
short-term financing is day’s accounts payable, i.e. the average number of days a
firm takes to pay its suppliers. Calculated as the average accounts payable x 365
divided by the cost of sales, empirical findings given the data sample show that
firms facing cash shortfall on average pay their suppliers in less time than firms
with surpluses, 50 and 64 days respectively. This confirms that firms on average
do not use deferred accounts payable payments as a tool when liquidity crises in
form of negative shocks occur. Furthermore, the result may be a reflection of
several factors, e.g. the business culture in the specific region or possibly a time
trend due to the chosen data period, and a specific cause may therefore be highly
intricate to determine
5.1.4 Hypothesis 4
The fourth hypothesis is that firms with high growth opportunities are less likely
to cut investment and instead more likely to be covering the shortfall with
external finance and dividend cuts. It is found that firms with high growth
opportunities are least likely to drawing down on cash balances and are instead
more likely to be selling assets and after by raising external finance or dividend
cuts.
A possible explanation for the findings is that high-growth firms, i.e.
assuming that high-growth opportunities stipulates high market-to-book-value,
utilizes external financing in greater extent since market recognizes the value of
their growth and thereby letting the firm face lower costs of external finance
(Daniel et al. (2011)).
Firms in some cases do perform dividend cutbacks in order to cover shortfalls,
but the source represents a relatively small amount in comparison with other
utilized sources. However, with findings of cutbacks throughout the different
determinants, firms do not show a clear sign of reluctance to cut dividends. This
in turn supports the view of firms facing shortfalls treat dividends as the residual
46
Examining the Sources of Financial Flexibility
and investment policy as being of first- order importance, contradicting Daniel et
al. (2011) .The findings are specifically clear when studying the results from the
determinant “financial crises”, showing that firms prioritize the maintenance of
investments. Firms are with the above stated, not constrained by the “the
dividend treadmill” in such extent that investment policies are to be viewed as a
residual. This supports the assumption in agency cost-based models that
dividends serve as a relatively poor constraint for managers when firms face
over-investment problems. The fact that managers are willing to cut dividends
when they could have avoided so, and instead cut investment, is affirming this
view suggested by Jensen (1986). Nevertheless, dividend-paying firms are less
likely to cut dividends to zero. Therefore it is not clear if dividend payers, as
according to literature, can be regarded as less financially constrained than nonpayers, using dividend cutbacks to cover shortfalls arising from investment
needs rather than using costly external financing.
5.1.5 Hypothesis 5
The fifth hypothesis, in consistency with DeAngelo and DeAngelo (1990) and
DeAngelo and DeAngelo (2007), is the conjecture that dividend-paying firms are
less likely to cut dividends to finance cash shortfalls due to firms with higher
dividend pay-out ratios have investors which are particular about maintaining
the dividend level. Firms would be more likely to cut investment. The results
show that firms with high pay-out ratios finance cash shortfalls primarily by
selling assets and then through external financing. They also cut on investments
and in some cases cut dividends. They are least likely to draw down on cash
balances.
Firms in the sample of this study are not very reluctant to cut dividends,
although it is usually a very small amount in comparison to other sources of
funds. Blau and Fuller (2008) find that firms tend to be unwilling to cut
dividends, a theory that should not be completely disregarded for our case, as
the average amount of cutting dividends is significantly small. Cutting dividends
is never a primary source for firms to cover for cash shortfalls, as with the case of
raising external financing.
47
Examining the Sources of Financial Flexibility
Fama and French (2001) state that, regardless of firm characteristics, firms are
becoming less likely to pay dividends to shareholders. As is clearly visible in
Table 8, firms increase dividends only in two cases. Firstly, when a firm has
reasonably high flexibility (score of 7), and secondly, if a financial crisis is absent.
It can therefore be stated that firms seldom increase dividends.
5.1.6 Hypothesis 6
The sixth hypothesis, is that dividends are treated as a residual and investment
policy as of first-order importance, firms’ facing shortfalls during financial crises,
e.g. credit crunches are more likely to cut dividends and sell assets since crises
can be seen as and exogenous shock. Firms are in these cases less likely to raise
external funds. It is found that firms facing shortfalls during financial crises are
most likely to sell assets followed by external financing. However, these firms
also cut dividends whilst firms with shortfalls increase dividends when financial
crisis is absent.
During the recent financial crisis (2007-2011), firms lost profitable investment
opportunities due to insufficient access to external funds. The ability to raise
external funds determines firms’ ability to invest in these opportunities
(Campello et al (2009)). However, the results in this study suggest that firms
included in this sample, on average, increase debt during a financial crisis than in
the absence of such.
The evidence that shortfalls occur more frequently during financial crises for the
firm-years, is not particularly strong where 67% of the shortfalls occur during
periods characterized as “financial crises”. However, supporting the findings by
Fazzerazi et al. (1988), the results in this study suggests that firms facing cash
shortfalls during financial increases their cash balances, on average 68% more
than firms not facing finance crises. This may indicate as suggested by Fazzerazi
et al. (1988), that firms are preparing for a future recession.
As previously stated in this thesis, previous finance literature (e.g. Greenwald et
al (1984) and Myers and Majluf (1984)) finds that managers restricts the use of
external finance and use internal funds (i.e. cash balances or cash flow) if the
firm faces high costs of external finance. Our results provide supporting
48
Examining the Sources of Financial Flexibility
conclusions for this earlier finding, where external financing is not the primary
source in any of the cases to cover for cash shortfalls (Table 9). This is also in line
with pecking-order theory. This may be explained by the fact that Sweden has
not a developed bond market yet, such as that in North America. This may be
causing firms not to have access to cheap sources of external finance in the same
extent as firms in the U.S., and therefore the pecking-order may have a different
preferential ordering for this geographical area (Table 8). Table 8 reports that
issuing debt is only significantly high for firms with a low Altman Z-score, low
excess cash holdings or low flexibility.
Byon (2008) stated that the preferential ordering of the pecking-order
hypothesis is reversed for high-growth firms, due to preservation of financial
flexibility. High market-to-book firms in Table 8 are do not issue considerably
high amounts of debt to cover for shortfalls, implying that his findings might not
be entirely accurate for the sample used in this study. For high market-to-book
firms, issuing debt comes after selling assets as the main source of funds, but
before using internal funds, reducing investments or cutting dividends.
49
Examining the Sources of Financial Flexibility
6 Conclusion
This is the final chapter, presenting concluding remarks from the conducted study.
In addition, it contains of suggestions for future research within the field of
financial flexibility.
The purpose of this study was to examine the source of financial flexibility and
where firms draw the necessary funds to resolve possible cash shortfalls. This is
especially interesting during period of unexpected growth opportunities and
negative shocks to firms’ cash flows. With the use of cross-sectional
determinants the degree of impact on financial policies was analysed. A firm’s
investment and financing decisions are dependent of a firm’s current state,
which in turn reflects current levels of uncertain variables and current financial
structure and capital levels. The latter are to be seen as a result of past decisions,
them in turn characterized by uncertainty about the future. Due to this
intertemporal link between decisions, we therefore recognize that financial
flexibility is “forward-looking” in that sense that that it is related to managers’
expectations of the probability of future negative shocks. The intertemporal
choices facing managers in form of transaction costs give is the core of financial
flexibility and what this thesis aimed to examine. The findings of our study are
not completely consistent with prior financial literature and bring new
information regarding financial flexibility for Swedish listed firms.
As discussed in the previous section, dividend-paying firms with a high pay-out
ratio are less likely to use internal funds to cover for the shortfall. Our findings
suggest that these firms seem to treat dividend policy as a residual rather than a
first-order priority. These results are somewhat inconsistent with DeAngelo and
DeAngelo (2007) and Daniel et al. (2011). Although we find that the average
funds generated from cutting dividends is relatively low across all sample firms
in comparison to other sources of funds, this however supports the view in
agency theory that dividends is a rather poor constraint on management.
50
Examining the Sources of Financial Flexibility
Asset sales are frequently recurring in the results as a main resort of solving cash
shortfalls. As previously stated, and demonstrated in chapter 4, firms with low
excess leverage are selling assets to cover for the shortfall but at the same time
are likely to increase investments. In this particular case, these firms will likely
sell non-core assets when doing so, as selling core assets to increase investments
is counter-intuitive. However, selling non-core assets is associated with a risk, as
the cost of selling those assets depends highly on the liquidity of the asset. Thus,
illiquid assets bear a possibly large transaction cost. If the assets are liquid and
sold at a low cost, it could be considered consistent with the pecking-order
theory. However, if the motive is unknown of the asset sale, market may perceive
the asset sale as less negative.
6.1 Future research
The factors we chose in to include in the model for calculating cash shortfalls are
not exhaustive. Campello et al. (2010) finds in their study that constrained firms
in the U.S. dramatically reduce employment by 11 % and marketing expenditures
by 33 %. This stresses that there is a need to investigate the role of other factors,
particularly in Sweden or Scandinavia, to see whether firms might reduce
employment levels, decrease marketing expenditures or similarly in order to
cover for shortfalls. Studies should further be extended to an international level
and aim to cover small- or mid-cap firms that faces more growth opportunities
and where the need for financial flexibility is most likely to be higher. Therefore,
such a study would provide valuable benefits enabling firms to adjust their
financial policies in a timely and value-maximizing manner. This would provide
further insight in to the field of financial flexibility.
51
Examining the Sources of Financial Flexibility
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Examining the Sources of Financial Flexibility
8 Appendix
Table 1 OMXS30 historic decomposistion
Aktie
Tidsperiod
Aktie
Tidsperiod
ABB A
1996:2 - 1991:1
MoDo B
1995:2 - 2000:1
ABB B
1996:2 - 1991:1
MTG B
2009:2 - 2010:2
ABB Ltd
1999:2 - 2010:2
Netcom B
1999:2 - 2001:1
Aga B
1995:1 - 1999:2
Nokia A
1997:2 - 2010:2
Asea A
1995:1 - 1996:1
Nordea
1998:2 - 2010:2
Asea B
1995:1 - 1996:1
Pharmacia & Upjohn
1996:2 - 2000:1
Alfa Laval
2003:1 - 2010:2
Pharmacia A
1995:2
Assa Abloy B
2001:1 - 2010:2
Pharmacia B
1995:1 - 1995:2 and 2000:2 - 2002:2
Astra A
1995:1 - 1999:1
Sandvik A
1995:1 - 2010:2
Astra B
1995:1 - 1999:1
Sandvik B
1995:1 - 2000:1
AstraZeneca
1999:2 - 2010:2
SCA B
1995:1 - 2010:2
Atlas Copco A
1995:1 - 2010:2
Scania B
1997:2 - 1999:2 and 2007:1 - 2010:2
Atlas Copco B
1995:1 - 2010:2
SEB A
1995:1 - 2010:2
Autoliv
1996:1 - 1997:1
Securitas B
2000:1 - 2010:2
Avesta Sheff.
1995:2 - 1998:1
SHB A
1995:1 - 2010:2
Boliden AB
2006:2 - 2010:2
Skandia
1995:1 - 2006:1
Celsius B
1995:1 - 1996:1
Skanska B
1995:1 - 2010:2
Drott B
2003:2 - 2004:1
SKF B
1995:1 - 2010:2
Electrolux B
1995:1 - 2010:2
Swedbank
1996:1 - 2010:2
Eniro
2001:2 - 2009:1
SSAB A
2007:2 - 2010:2
Ericsson B
1995:1 - 2010:2
Stora A
1995:1 - 1998:2
Europolitan
2001:2 - 2003:1
Stora B
1995:1 - 1997:2
Fabege B
2004:2 and 2005:2 - 2006:1
Stora Enso A
1999:1 - 1999:2
Framtidsfabriken
2000:2 - 2001:1
Stora Enso R
1999:2 - 2010:1
Gambro B
1995:1
Sydkraft C
1995:1
Getinge B
2009:2 - 2010:2
Swedish Match
2003:1 - 2010:2
H&M B
1995:1 - 2010:2
Tele2 B
2001:2 - 2010:2
Holmen B
2000:2 - 2006:2
Telia
2000:2 - 2010:2
Icon Medialab
2000:1 - 2001:1
Trelleborg B
1995:1 - 2000:2
Incentive B
1995:1 - 1995:2
Trygg-Hansa B
1995:1
Investor A
1995:1 - 1997:1
Wihlborgs
2005:1
Investor B
1995:1 - 2010:2
WM-Data B
2000:1 - 2002:2
Kinnevik B
1996:1 - 2000:2
Volvo B
1995:1 - 2010:2
Lundin Petroleum AB
2008:1 - 2010:2
Vostok Gas
2006:2 - 2008:2
58
Examining the Sources of Financial Flexibility
Graph 2
OMXS30 - OMX Stockholm 30 Index
1800.00
1600.00
1400.00
1200.00
1000.00
800.00
600.00
400.00
200.00
0.00
Graph 3
S&P500 - Standard & Poor 500
1800.00
1600.00
1400.00
1200.00
1000.00
800.00
600.00
400.00
200.00
0.00
59
Examining the Sources of Financial Flexibility
Table 5 Resolving shortfalls
Panel A: Payers
Shortfall > 0
Shortfall in
the top
quintile (0,99)
Shortfall ≤ 0
Shortfall in
the bottom
quintile
MSEK
% of Shortfall
funded by
source
% of firms
where source is
positive
N (firmyears)
Expected
Investment
(MSEK)
Expected
Dividends
(MSEK)
Available
Cash
Flow
(MSEK)
Shortfall
(MSEK)
Dividend
cutback
Investment
cutback
External
cash
Nonoperating
cash
Cash
drawdown
63
4899
2084
4557
2426
441
-411
1632
7071
-4091
9%
-9%
35%
152%
-88%
30%
57%
51%
87%
21%
9105
-6432
22542
14252
-21513
51%
-36%
126%
79%
-120%
-545
-3711
-859
10277
-12455
7%
51%
12%
-141%
171%
13%
36%
36%
94%
11%
-2491
-15173
-9425
39165
-27007
17%
102%
63%
-262%
181%
MSEK
28283
% of Shortfall
funded by
source
SEK
% of Shortfall
funded by
source
% of firms
where source is
positive
224
5716
3375
17808
MSEK
% of Shortfall
funded by
source
-8717
-67822
Panel B: Non-Payers
MSEK
Shortfall > 0
Expected
Investment
(MSEK)
Expected
Dividends
(MSEK)
Available
Cash
Flow
(MSEK)
Shortfall
(MSEK)
Dividend
cutback
Investment
cutback
External
cash
Nonoperating
cash
Cash
drawdown
6
5640
0
2698
2943
0
2023
3550
18258
-1041
0%
9%
16%
80%
-5%
0%
67%
67%
100%
33%
0
5513
14044
55645
-14662
0%
9%
23%
92%
-24%
-563
-588
-769
6057
-7683
16%
17%
22%
-171%
217%
0%
44%
28%
94%
0%
-1526
2071
-266
68351
-14084
-3%
4%
0%
125%
-26%
% of Shortfall
funded by
source
% of firms
where source
is positive
Shortfall in
the top
quintile
MSEK
% of Shortfall
funded by
source
Shortfall ≤ 0
MSEK
% of Shortfall
funded by
source
% of firms
where source
is positive
Shortfall in
the bottom
quintile
N (firmyears)
11208
18
3533
0
6806
MSEK
% of Shortfall
funded by
source
-3273
-8202
60
Examining the Sources of Financial Flexibility
Table 7 Resolving shortfalls (Expected Investments = Actual Investment)
Panel A: Payers
Shortfall > 0
Shortfall in
the top
quintile
(0,99)
Shortfall ≤ 0
Shortfall in
the bottom
quintile
MSEK
% of Shortfall
funded by
source
% of firms
where source
is positive
N (firmyears)
Expected
Investment
(MSEK)
Expected
Dividends
(MSEK)
Available
Cash
Flow
(MSEK)
Shortfall
(MSEK)
Dividend
cutback
Investment
cutback
External
cash
Nonoperating
cash
Cash
drawdown
75
NA
2676
8208
4213
107
NA
1988
9985
-6638
2%
NA
37%
183%
-122%
24%
NA
59%
95%
23%
9105
NA
22542
14252
-21513
37%
NA
92%
58%
-88%
-486
NA
-1123
9384
-12024
11%
NA
26%
-221%
283%
15%
NA
32%
92%
9%
-54818
-2206
NA
-18741
38077
-20990
34715
57%
NA
486%
-987%
544%
MSEK
34715
% of Shortfall
funded by
source
SEK
% of Shortfall
funded by
source
% of firms
where source
is positive
213
NA
3223
17228
MSEK
% of Shortfall
funded by
source
-5931
Panel B: Non-Payers
Shortfall > 0
Shortfall in
the top
quintile
MSEK
% of Shortfall
funded by
source
% of firms
where
source is
positive
Shortfall in
the bottom
quintile
Expected
Investment
(MSEK)
Expected
Dividends
(MSEK)
Available
Cash
Flow
(MSEK)
Shortfall
(MSEK)
Dividend
cutback
Investment
cutback
External
cash
Nonoperating
cash
Cash
drawdown
7
NA
0
1887
1358
0
NA
5460
8498
-5525
0%
NA
65%
101%
-66%
0%
NA
86%
100%
14%
0
NA
14044
55645
-14662
0%
NA
26%
101%
-27%
-563
NA
-1883
9943
-5916
-36%
NA
-119%
629%
-374%
0%
NA
19%
94%
6%
-1526
NA
-266
68351
-14084
- 3%
NA
-1%
130%
-27%
MSEK
% of Shortfall
funded by
source
MSEK
Shortfall ≤ 0
N (firmyears)
5695
16
NA
0
7271
-2991
% of Shortfall
funded by
source
% of firms
where
source is
positive
MSEK
% of Shortfall
funded by
source
-10273
61
Examining the Sources of Financial Flexibility
Table 8 Resolving shortfalls – impact of determinants and financial flexibility
Payers - Presented as MSEK & % of Shortfall funded by source
Financial flexibility
measures
N
(firmyears)
Low
Excess
Leverage
Shortfall
(MSEK)
Dividend
cutback
1921
111
-704
2%
-11%
2915
Investment
cutback
Nonoperating
cash
Cash
drawdown
-665
7170
-1380
-10%
111%
-21%
-6717
External
cash
761
-127
3857
6975
16%
-2%
50%
91%
-88%
444
-436
2527
3462
-6869
-51%
-37%
213%
292%
-579%
437
-382
583
11302
-833
4%
-3%
4%
81%
-6%
794
-604
3592
8039
-6499
15%
-11%
67%
151%
-122%
High
2057
Low
Excess Cash
Holdings
2858
High
3270
Low
Z-score
1555
77
-211
-391
6071
-1605
2%
-5%
-10%
154%
-41%
2381
669
-251
2458
7249
-475
7%
-3%
25%
75%
-5%
2469
220
-566
833
6899
-7593
-106%
272%
-400%
-3316%
3649%
High
Low
Short-term
Debt/Total Debt
High
Low = 4
Overall
Flexibility Score
8
5
18
6
14
7
16
4469
1231
3491
2478
914
High = 8
7
949
-778
2985
7953
-17132
-16%
13%
-50%
-132%
284%
57
-27
3594
1525
-5591
-13%
6%
-815%
-346%
1268%
1403
-839
2653
12076
-658
10%
-6%
18%
83%
-4%
-54
-406
-809
8997
-1928
-1%
-7%
-14%
155%
-33%
54
-135
-1421
2864
5912
1%
-2%
-20%
39%
81%
304
2%
339
3%
1827
15%
10500
85%
-553
-4%
Other Firm Characteristics
Yes
19
2631
44
2730
Long-lived Shock
No
Low
32
3717
31
1093
619
-579
1432
6867
-4302
15%
-14%
35%
170%
-107%
617
9%
-1140
-16%
1852
26%
11585
161%
-5733
-80%
Market-to-book
High
Low
29
2956
34
1974
259
341
1405
2412
-2396
13%
17%
69%
119%
-118%
591
7%
-1094
-12%
2517
28%
6610
75%
211
2%
Payout Ratio
High
Yes
313
172
878
3646
-7760
-11%
-6%
-32%
-133%
282%
42
3050
720
10%
-238
-3%
2603
37%
8600
124%
-4726
-68%
21
1177
-118
-1083%
-757
-6978%
-309
-2851%
4014
37005%
-2819
-25993%
Financial Crises
No
62
Examining the Sources of Financial Flexibility
Table 9
Hypothesis 1
Highest flexibility
Results
Less likely
More likely
Cut investment
Internal/External funds
(1) External funds and (2) cut investment
(1) Internal funds, (2) sell assets and (3) cut dividends
Cut investment
External funds
(1) Internal funds, (2) cut investment and (3) external
funds
(1) Sell assets, (2) cut dividends
External funds
Internal funds, cut investment
(1) Internal funds, (2) cut investment
(1) Sell assets, (2) external funds, (3) cut dividends
Cut investment
External funds, cut dividends
Internal funds
(1) Sell assets, (2) external funds, (3) cut investment, (4)
cut dividends
Cut dividends
Cut investment
Internal funds
(1) Sell assets, (2) external funds, (3) cut dividends, (4)
cut investment
External funds
Cut dividends, sell assets
(1) Sell assets, (2) external funds, (3) cut dividends
(1) Internal funds, (2) cut investment
Hypothesis 2
Low excess leverage
/ high excess cash
Results
Hypothesis 3
High short-term debt
Results
Hypothesis 4
High growth
Results
Hypothesis 5
High pay-out ratio
Results
Hypothesis 6
Financial Crises
Results
63
Examining the Sources of Financial Flexibility
64