How and Why Do Firms Establish Financial Flexibility?1Özgür Arslan a, Chrisostomos Florackis b and Aydin Ozkan c*
a Hacettepe University, Turkey
b University of Liverpool, UK
c University of Hull, UK
ABSTRACT
This paper investigates the issue of financial flexibility using a large sample of firms from five East Asian countries before and during the East Asian financial crisis. Our main objective is to examine the effects of financial flexibility on firms’ corporate investment and performance. In doing so, we measure financial flexibility considering the leverage and cash holdings policies of firms in the pre crisis period, while we test the hypotheses in relation to the link between flexibility, investment and performance during the crisis period. We find that firms with low levels of leverage and high cash balances prior to the crisis have greater flexibility in taking investment opportunities during the crisis. Furthermore, they rely much less on the availability of internal funds than less flexible firms and hence their ability to invest is greater. We also
brooke fraserfind that the performance of flexible firms, measured using alternative indicators, is better during the crisis. Finally, the findings show that business group affiliation of firms does not act as a substitute for financial flexibility during the crisis. Regardless of their business group affiliation, the investment expenditures of less flexible firms are significantly sensitive to the availability of internal funds.
JEL classification: G31; G32
Keywords: Financial flexibility, corporate liquidity, investment, financial crisis, business groups
1We are grateful to Viral Acharya, Matthew T. Billett, Jon A. Garfinkel, Marc Goergen, Klaus Gugler, Alexandros Kostakis, Leone Leonida, Maria-Teresa Marchica, Roberto Mura, Uday Rajan and seminar participants at the ESRC seminar on Corporate Governance, Regulation, and Development at the University of Birmingham; the workshop on Methods and Applications in Macroeconomics and Finance at Ege University; and Hull University Business School for helpful comments and suggestions on earlier versions of the paper.
*Corresponding author. Hull University Business School, HU6 7RX, Hull, Tel.: +44 1482 463789, E-mail: A.Ozkan@hull.ac.uk.
1. Introduction
There is ample evidence in the literature that financial executives see financial flexibility as one of the most important determinants of capital structure decisions (Graham and Harvey, 2001; Bancel and Mittoo, 2004; and Brounen et al., 2006). Financial flexibility is generally defined as the ability of a firm to access and restructure its financing at a low cost (see, e.g., Gamba and Triantis, 2008; and Byoun, 2008a) and the motives to attain flexibility are related to the ability and the need of firms to raise external funds. For instance, it is argued that financially flexible firms have easier access to external financial markets to meet future funding needs arising from unanticipated earnings shortfalls and/or new profitable investment opportunities (DeAngelo and DeAngelo, 2007). These firms are also able to avoid financial distress in the face of negative shocks (Gamba and Triantis, 2008). It is hence implied that firms that sacrifice financial flexibility risk future investment distortions when exogenous shocks to earnings and/or new investment opportunities require additional funding.23
In this paper we study the implications of financial flexibility for corporate investment and performance. In doing so, we focus on the interplay between financial flexibility and investment during abnormal economic circumstances such as the East Asian financial crisis of 1997. The crucial question we address is to what extent financial flexibility at the onset of a crisis helps firms maintain their investment policy and performance at satisfactory levels during the crisis. Our main hypothesis in this r
espect is that the higher a firm’s financial flexibility at the onset of a crisis, the less severe the decline in its performance and investment expenditures during the crisis.
2 Clearly, similar views are also raised in the earlier literature. The pecking order theory of capital structure, proposed by Myers (1984) and Myers and Majluf (1984), is based on the assumption that firms seek to preserve financial slack to avoid the need for external funds in financing future investment opportunities. Also, Froot et al. (1993) suggest that firms can hedge or maintain financial flexibility to avoid underinvestment costs.
3 Also see Byoun (2008b) for an extensive review on the concept of financial flexibility.
We carry out our analysis by incorporating data from over 1,000 firms in five East Asian countries which were adversely affected by the East Asian financial crisis. Focusing on this period provides us with clear advantages. Economic and financial crises clearly represent exogenous shocks to firms’ viability, profitability and cash flows. Moreover, not only do they reduce the expected return on investment opportunities, but crises also create opportunities, due to lower asset prices, for firms with the ability to invest (Mitton, 2002).
A crisis period would therefore allow us to provide stronger tests on the impact of financial flexibility on
corporate investment and value by examining the performance and investment policy of flexible – and less flexible – firms during the crisis. Moreover, the crisis period offers us an opportunity to distinguish between the incentives to attain flexibility in the pre crisis period and the benefits of flexibility in the crisis period. While the former stresses on why and what types of firms attempt to attain financial flexibility, the latter focuses on the circumstances in which flexibility matters the most. Clearly, testing the relevance of financial flexibility for firm value and investment is more likely to provide strong inferences in “abnormal” times when flexibility is most needed. By the same token, the effects of financial flexibility on corporate investment and value would be less evident prior to the crisis when times are “normal”.
In this paper, we first tackle the issue of the measurement of financial flexibility. Although financial flexibility is generally viewed as desirable, there are nevertheless no clear cut indications in the literature as to how exactly it is attained. Prior research mainly focuses on the leverage and cash holdings policies of firms as the ways firms can preserve flexibility. However, the bulk of the literature in this area investigates cash and leverage policies separately. On the one hand, a number of studies emphasize the importance of obtaining financial flexibility through low leverage policies, (Poitevin, 1989; Goldstein et al., 2001; Billet et al., 2007; and Byoun, 2008a). On the other hand, there is a stream of
studies which focus on the role of cash balances of firms in achieving financial flexibility (Opler et al., 1999; Almeida et al., 2004; Acharya et al., 2007; Faulkender and Wang, 2006; Dittmar and Mahrt-Smith, 2007; Harford et al., 2008; and Riddick and Whited, 2008). The main argument of both lines of research is that firms with readily available large cash balances or low leverage (i.e. debt capacity) can better cope with earnings shortfalls and hence avoid underinvestment costs.
Recently, there has also been a growing interest in the view that firms can attain financial flexibility through both debt financing and liquidity decisions. For example, DeAngelo and DeAngelo (2007) explicitly consider leverage and cash holdings to define financial flexibility and argue that low leverage combined with moderate cash holdings and high dividend payouts constitute an “optimal” policy regarding flexibility.4 In line with this view, Gamba and Triantis (2008) show that financial flexibility, in addition to being determined by external financing costs, can also be a result of the firm’s strategic decisions regarding its capital structure, liquidity and investment. Moreover, Bates et al. (2008) argue that high cash holdings are related to low levels of debt in the light of increased risk in the economic environment, hence the simultaneous practice of these policies enable firms to forestall distress and default. Finally, Byoun (2008a) finds that small developing firms have a relatively higher tendency for seeking financial flexibility and thus resort to both lower leverage and larger cash holdings policies.
In measuring financial flexibility we consider both corporate leverage and liquidity structures in the pre crisis period. Specifically, in the first part of our analysis, we start by acknowledging that firms in “normal” times can attain financial flexibility by maintaining either a low leverage policy or large amounts of liquid assets. We also note that there will be firms that combine both policies to attain flexibility. The main objective of the analysis
4 Blau and Fuller (2008) also consider the link between flexibility and dividend policy focusing on the effects of flexibility on dividends.
in this part is to classify firms, on the basis of their pre crisis financial policies, into several categories of financial flexibility. Further, in carrying out this analysis we also aim to provide insights into the characteristics of firms that differ in the extent of financial flexibility. In doing so, detailed descriptive statistics are provided for six subgroups, namely low leverage; high leverage; low cash; high cash; low leverage and high cash; and high leverage and low cash firms. Moreover, we provide comparative statistics by providing a descriptive analysis for the same groups of firms in the crisis period.
In the second stage of our empirical analysis we take the flexibility characteristics of firms as given and examine whether firms attaining financial flexibility ex ante (i.e. pre crisis period) benefit from it in term
s of a greater ability to take investment opportunities and higher performance during the crisis period. While it is possible that firms can continue to desire financial flexibility during the crisis period, we assume that it is more likely that during this period firms will focus on optimally responding to the adverse conditions of the crisis. To address the relationship between financial flexibility and investment we estimate the cash flow sensitivity of investment of firms to provide insights into the reliance of each group of firms (i.e. flexible vs. less flexible) on the availability of internal funds. We also test if the performance of firms with greater flexibility differs from that of less flexible firms by estimating alternative performance models.
The current study adds to the literature that investigates the effects of financial crises on corporate performance and provides additional insights in the recent literature on the value of financial flexibility. While prior research presents strong evidence for the importance of several firm characteristics, such as ownership structure and corporate governance, in explaining differences in firm performance during the crisis (see, e.g., Johnson et. al, 2000; Mitton, 2002; Lemmon and Lins, 2003; Fisman, 2002), our analysis concentrates on the role that financial flexibility plays in determining the performance of
firms and their ability to invest in profitable investment opportunities, especially during periods characterized by sudden, unanticipated earnings shortfalls. Specifically, while also considering differen
ces in ownership structure and corporate governance across firms, the larger question we attempt to answer here is whether the adoption of suboptimal financial policies in a pre crisis period, which leads to the lack of corporate liquidity, makes firms particularly vulnerable during a crisis period.
Another important aspect of our study is that it investigates whether business group affiliations can affect the investment behaviour of firms in the crisis period as well as the interaction between financial flexibility, investment and firm performance. Under the light of the findings of Hoshi et al. (1991) and Khanna and Palepu (2000), we expect that firms with business group affiliations will, ceteris paribus, have easier access to external financing, higher investment expenditures, and better performance during the crisis period. Additionally, it is possible that the value enhancing effects of financial flexibility - attained through particular leverage and cash policies - in the face of negative external shocks will be less pronounced in firms that belong to a business group because business affiliation is expected to play a similar role to that of financial flexibility (i.e. substitution effect). Thus, in our empirical analysis we also investigate whether financial flexibility can be attained through business group affiliation instead of low leverage and high cash policies.
Our study is related to several strands of the growing literature on financial flexibility and financial constraints. Arslan et al. (2006), for example, examine the impact of cash balances on the sensitivity of
investment expenditures of firms to cash flows during a financial crisis using a dataset of Turkish non financial companies. They find that the reliance of financially constrained firms on internal finance increases during the financial crisis and, more interestingly, the investment expenditures of cash poor firms are
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