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E-MailJohn Graham is the D. Richard Mead, Jr. Family Professor at Duke University’s Fuqua School of Business and Mark Leary is Associate Professor of Finance at Washington University in St. Louis’ Olin School of Business. This post is based on a recent article by Professor Graham and Professor Leary, forthcoming in The Review of Financial Studies.
The large increase in corporate cash balances in recent years has garnered much attention in both the academic literature and popular press. Several explanations for this apparent shift in corporate policies have been proposed, including increased riskiness of corporate cash flows, a change in the nature of firms’ assets or the nature of firms going public, a decline in the opportunity cost of holding cash (due to low interest rates), agency conflicts, and U.S. repatriation tax law, which led to trapped foreign cash. While each of these hypotheses is instructive, to fully understand what is different about modern cash policies and what drives time-series changes in corporate cash, one needs to put the recent trends in historical perspective. We gather data back to 1920 to provide this perspective.
To understand these changing patterns in cash holdings, we perform separate cross-sectional and aggregate time-series analyses, leading to several new insights: First, cross-sectional patterns in cash holdings have been stable over the past 90 years: holding sample composition constant, the types of firms that have high (low) cash holdings in recent years have had high (low) cash in nearly every decade over the last century. This is surprising, given that the development of financial markets over the century has arguably reduced the relative importance of financial frictions relevant for cash policies, such as transaction costs and informational frictions. One might have expected that this would lead to a shift in the determinants of cash policies over time, which could also drive time-series variation in cash holdings.
Second, even with stable cross-sectional sensitivities, changing sample composition led to changes in the distribution of cash holdings. In particular, the influx of new, primarily Nasdaq firms since 1980 led to notable changes in both firm characteristics and sensitivities of cash holdings to those characteristics. Recent research has documented high cash balances post-1980 among firms with low profits, sales, current assets, and debt access. We show that the increase in average cash ratios between 1980 and 2000 is entirely driven by these new entrants. Even with increasing average cash, within-firm changes in cash are flat-to-negative over the 1980s and 1990s. This therefore implies that new (Nasdaq IPO) firms entering the sample with substantial cash holdings led to the increase the overall average cash ratio. This is in sharp contrast to the distribution of cash policies over much of the century, which was marked by a stable cross-sectional dispersion, similar cash levels between the largest and smallest firms, and substantial within-firm changes in cash ratios. Thus, while many of the factors that determined cash policies in the 1920s are still relevant today, changes in the composition of publicly traded firms, as well as sensitivities to factors that affect cash holdings, have dramatically affected the cross-sectional distribution of cash holdings in recent decades. This supports the view that the nature of a firm’s assets is an important driver of cash policies (e.g., Falato et al., 2013, Booth and Zhou, 2013, Begenau and Palazzo, 2017, and Denis and McKeon, 2017).
Third, while these recent changes in characteristics of publicly traded firms affected average cash holdings, they are not the primary force behind time-series patterns in economy-wide (aggregate) cash holdings. Much of the recent concern over high cash balances focuses on the amount of capital sitting “idle” on corporate balance sheets. To the extent that corporate cash management decisions impact money demand and economic growth, it is important to understand the drivers of aggregate cash holdings by the corporate sector. Contrary to the average, aggregate cash has been relatively stable in recent decades. Further, while differences in cash holdings across firm types within a given cross-section are fairly stable, the entire distribution shifts over time in a way that is largely unrelated to aggregate characteristics. As a result, firm characteristics do not explain much of the time-series. Rather, changes in aggregate corporate cash over the century are primarily driven by macroeconomic variables (primarily aggregate productivity and GDP growth), corporate profitability and investment, and since 2000, repatriation taxes (regarding repatriation, see also Foley et al., 2007, and Faulkender et al., 2018).
Specifically, the factors that provide the most explanatory power for time-series variation in aggregate cash are simply contemporaneous cash flows and investment expenditures. (Combined with productivity, these variables explain nearly half of the variation in aggregate cash.) Thus, while we find some evidence that firms have cash level targets, much of the year-to-year fluctuations in cash holdings stem from accumulation of profits and the use of those profits to fund investment. These results are consistent with firms adhering loosely to cash targets, perhaps allowing cash to vary within upper and lower boundaries due to adjustment costs (Miller and Orr, 1966; Bolton, Chen and Wang, 2011).
The century-long perspective we provide has several advantages. First, we are able to describe how cash policies of today are similar to, and depart from, those in the past. This provides a deeper understanding of the nature of the modern cash “puzzle.” Second, having nearly a century of data uniquely positions us to study the determinants of changes in aggregate corporate cash holdings through time. Our findings highlight the importance of business cycle fluctuations on money supply and corporate asset allocation. Moreover, because trapped foreign cash is a modern issue, and our sample includes many decades before repatriation tax incentives became binding for U.S. firms, our paper sheds light on how cash policy may work now that the 2018 tax reform largely eliminated foreign profit repatriation issues.
Finally, we provide a rich set of empirical facts to guide development of cash theories. For example, our evidence suggests the frictions relevant for determining cash targets, at least among NYSE firms, are similar throughout the century. At the same time, our evidence suggests firms are unconcerned about modest deviations from cash targets. Dynamic cash theories should allow for this passive short-run behavior. Lastly, explanations for the increase in average cash in recent decades should be consistent with declining within-firm cash balances and increasing cash ratios among new, primarily Nasdaq-like firms in the tech and health sectors.
The complete article is available for download here.
