Cash Holding and Corporate Performance

University van Amsterdam Amsterdam Business School BSc Economics & Business Specialization Finance &Organization

Author: Tianyang Lan Student number: 10846492 Thesis supervisor: Dr. J.E.(Jeroen) Ligterink Finish date: 01-2018

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Statement of Originality This document is written by Student Tianyang Lan, who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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ABSTRACT There are articles stating that holding cash has certain advantages to the company, while there

are evidence showing that cash may be harmful. The aim of this thesis is to find the relationship

between the cash holding of the company and the company performance in Europe. It provides

the regression analysis based on the data of European companies. The result shows that there is a

negative relationship between the cash and the performance in Europe, but the relationship

becomes positive during the time of financial crisis. It suggests that holding too much cash is bad

for the company, but during the recession time, the excess cash may be good for the company

performance.

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Chapter 1: Introduction

The rising cash holdings of U.S. firms are increasingly in the hands of a few U.S.

companies, for which Apple, Microsoft, Alphabet, Cisco Systems and Oracle are

sitting on $504 billion, that is 30% of the 1.7 trillion in cash and cash equivalents

held by U.S. non-financial companies in 2015 (Krantz, 2016). The question is why

would these companies own such a large number of cash on hand. Krantz also

mentions that Apple shows the strong disconnect between big cash balances and

stock return, and the investors have lost $240 billion in paper profits since the

stock peaked (2016). It can be argued that excess cash holding of a company may

harm the interest of investors. On the other hand, Seth Klarman, as on the the best

value investors in history, always keeps a significant portion of his portfolio in

cash, and since he founded Baupost Group in 1982, it has achieved high teens

returns for investors every year (Hargreaves, 2017). Therefore, it can also be

supported that holding cash may be possible to benefit the investors. Since the

excess cash can bring both benefits and costs to the shareholders, it is worth to

investigate whether the firms are willing to hold more cash or not. If cash may

affect the performance of firms. The central research question of this paper is to

discuss the relationships between the company performance and the cash holding

level in Europe area, and would the factor of recession influences this relationship.

Although some of the articles already did the similar test, most of them are

focusing on the U.S. or global market. There are very few articles discussing the

relations between cash and performance of European firms. This paper contributes

to the existing literatures by reporting the test result of Europe, since the analysis

will be based on the data of European market.

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The remainder of this paper will be construct as follow: Chapter 2 will be

the literature review, showing the discussion of existing studies. The methodology

will be introduced in Chapter 3. Chapter 4 will show the data and summery

statistics. In Chapter 5, the analysis results will be discussed. Finally, there will be

a conclusion and further discussions in Chapter 6.

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Chapter 2: Literature review

2.1. Benefits of Cash

Based on the existing literature, it can be argued that holding cash has both

benefits and drawbacks. According to Haushalter, holding cash has certain benefits

since it may enhance the flexibility and in strategic response and provides

deterrence (2007). When external financing costs too much, cash allows firms to

invest in opportunities and reduces the risk of underinvesting in strategic

opportunities (Nason, 2016). Almeida argues that the company with higher cash

holdings generally has higher capacity to undertake profitable investment

opportunities (2004). In addition, Acharya (2005) provides evidence that cash

holding may secure investment through hedging against cash flow deficits. It can

be suggested that the holding excess cash is able to reduce the impact of financing

frictions and fluctuations in the availability of internal funds on investment

(Arslan, 2006). Therefore, holding cash may have positive effects on companies.

2.2. Costs of Cash

On the other hand, holding cash may bring certain drawbacks to the

company. According to Kalcheva and Lins, the cash held by firm may lead to a

managerial agency problem (2007). The agency problem occurs when there are

conflicts of interest between the shareholders and managers over the payout policy,

and the conflicts are severe if the firm generates substantial cash flow, in which the

problem is how to motivate managers to disgorge the cash rather than investing it

at below the cost of capital or wasting it (Jensen, 1986). It is possible to have over-

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investment in less profitable opportunities in a company (Richardson, 2006).

Hence, cash holding may also have a negative influence on the performance.

2.3. The Effects of Financial Crisis

The recession around 2008 can be argued as one of the most serious crises in

the global financial markets. During a crisis, firms face tighter financial constraints

and as a result this is a relevant period to test the importance of this channel of the

benefits of cash holdings.

Song and Lee (2012) concludes that the financial crisis has systematically

changed the cash holing policy of firms. If the economy is bad and deteriorating,

managers increase cash holdings to prepare for the uncertainty in the economy, and

managers should deplete the cash reserve to exercise growth opportunities when

the economy is good and improving in the future (Chen, 2015).

2.4. Test results in US market

Nason and Patel (2016) use the sample of publicly traded manufacturing

U.S. firms between 2004 and 2010 to examine whether the relationship between

cash and stock market performance changes during the economic crisis. Their

result shows the relation between the cash holding and the corporation

performance is positive, and the overall benefits of holding cash shows to be lower

in the pre-recessionary period, which means it is better for firms to hold cash

during the crisis period.

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2.5. Hypothesis

The test of this paper is going to be focus on Europe market. Since both of

US and Europe are developed, it can be expected that it will generate the same

conclusion as with Nason and Patel (2015). Therefore, the hypothesis of this paper

is there is a positive relationship between the cash holding and the company

performance of the selected firms for the sample period, and the relationship would

become stronger during the financial crisis.

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Chapter 3: Model

The regression model of this paper is as follow:

𝑅𝑂𝐴 = 𝛽& + 𝛽(𝐶𝑎𝑠ℎ + 𝛽-𝐴𝑏𝑠𝑜𝑟𝑏𝑒𝑑𝑠𝑙𝑎𝑐𝑘 + 𝛽7𝐷𝑒𝑏𝑡𝑟𝑎𝑡𝑖𝑜 + 𝛽;𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑛𝑡𝑒𝑛𝑠𝑖𝑡𝑦+ 𝛽?𝐹𝑖𝑟𝑚𝑠𝑖𝑧𝑒 + 𝛽C𝑅𝑒𝑐𝑒𝑠𝑠𝑖𝑜𝑛 ∗ 𝐶𝑎𝑠ℎ + 𝜀

As the dependent variable of this model, ROA can be seen as a measurement of

company performance, it reflects the ability of a company to generate profit by

using the asset. Since ROA is not easy to be manipulated, it can be a more

objective measurement for company performance (Zhang, 2011). As the aim of

this paper is to test the affect of cash holdings on the performance, the explanatory

variable is cash, which is measured as the logarithm of total cash and short-term

investment of a company. According to the researches regarding to the factors that

affect the company performance, it can be argued that the selling volume,

expenditure scales, debt scales, and the firm size may all influence the

performance. In order to better perform the test, the similar control variables which

are in line with these factors as Nason and Patel (2016) had will be used in this

paper. Absorbed slack can be measured by the ratio of selling and general expense

to sales. According to Tan, slack buffers a firm’s technical core from

environmental turbulence, but also may cause agency problems, that may influence

performance (2003). Debt ratio is the ratio of total debt to total asset. Furthermore,

the Capital intensity can be calculated by using the capital expenditure scaled by

sales. Also, the logarithm of total asset is going to be used as the representative of

the Firm size. Afterwards, a regression dummy multiplied by cash is added to the

model, in order to test the relationship between the total cash holding and

performance of the firm.

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Chapter 4: Data and Summary Statistics

The data of this paper are all collected from Compustat database on Wharton

Research Data Services website (WRDS). 40 companies from different countries in

Europe are selected as the samples of this paper from the list of largest European

companies by revenue (2018). The list of all the 40 companies are shown on Table

1, includes the Industry details and country of headquarter.

Table 1

List of Companies

Company Industry Country Air France-KLM Aviation France Airbus Aeronautics and defence France Alstom Conglomerate France Anglo American Mining United Kingdom AstraZeneca Pharmaceuticals United Kingdom BASF Chemicals Germany Bayer Pharmaceuticals Germany Bouygues Conglomerate France BP Oil and gas United Kingdom Carrefour Retail France Centrica Electric utility United Kingdom Continental Auto and truck parts Germany Daimler Automotive Germany Deutsche Post Postal services Germany Deutsche Telekom Telecommunications Germany E.ON Electric utility Germany Enel Electric utility Italy Engie Electric utility France Ericsson Electronics Sweden

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Exor Investment Italy GlaxoSmithKline Pharmaceuticals United Kingdom Nestlé Consumer goods Switzerland Nokia Electronics Finland Novartis Pharmaceuticals Switzerland OMV Oil and gas Austria Orange Telecommunications France Repsol Oil and gas Spain Rosneft Oil and gas Russia Royal Dutch Shell Oil and gas Netherlands Schneider Electric Electrical equipment France Siemens Conglomerate Germany Sistema Conglomerate Russia Statoil Oil and gas Norway Telecom Italia Telecommunications Italy Telefónica Telecommunications Spain Unilever Consumer goods Netherlands Vinci Construction France Vivendi Mass media France Volkswagen Automotive Germany Volvo Heavy equipment Sweden

This table reports the list of 40 sample companies, including the industries and the countries.

The data of all the 40 companies from 2005 to the end of 2017 will be used

to do the regression test. According to the timeline of the major events during the

financial collapse period from the paper of Hausman and Johnston, in February

2007, HSBC announces loan loss provisions signaling the issues with sub-prime

loans, and in February 2009, countries introduce new regulations over banking

industry, increase the control in banks that with troubled assets and infuse more

money into the economies (2014). Therefore, the time from the beginning of 2007

to the second quarter of 2009 is set as the financial crisis period. Figure 1 shows

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the average cash to total asset ratio of all 40 companies across the whole period. It

is shown that the cash holding starts to decrease from 2007 and increases after the

beginning of 2009. Starting from 2009, the total cash to asset ratio are fluctuated

around 0.1. It is worth to be mentioned that the amount of cash relative to asset

rapidly increases during the period of 2007-09 to 2008-03.

Figure 1

This chart indicates the average of total cash and short-term investment to total asset ratio of all the 40 sample companies over the sample period of time.

Table 2 records the means and standard deviations of all the variables, and

the correlations among the variables. All the other correlations are not significantly

large except the correlation between the log of cash holding and the firm size. It

0.08

0.1

0.12

ChartofCashtoAssetRatio

cash/asset

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reports the correlation between these two variables is 0.848, which means the size

of a firm might be positively highly correlated with the cash holding. This high

correlation is reasonable since the firm size is calculated by the logarithm of total

asset, which includes all the cash and short term investment.

Table 2

Means, standard deviations, and correlations

Mean SD ROA cashlogAbsorbedslack

Debtratio

Capitalintensity Size

recession*cash

ROA 0.012 0.015 1 cashlog 3.807 0.508 -0.0957 1 Absorbedslack 0.825 0.112 -0.353 -0.0561 1 Debtratio 0.262 0.121 -0.181 0.0513 -0.271 1 Capitalintensity 0.169 0.161 -0.199 0.125 -0.325 0.289 1 Size 4.896 0.456 -0.0938 0.848 -0.0894 0.100 0.195 1 recession*cash 0.736 1.484 0.110 -0.0777 -0.0543 -0.0376 -0.033 -0.043 1

This table reports the sample mean, standard deviation of all the variables, and the correlation among the variables.

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Chapter 5: Regression Analysis and Discussion

The robust regression test was performed on STATA, and Table 3 reports

the summary of the regression results that does not include the recession dummy.

It indicates that the coefficient of logarithm of cash is -0.0027, and the p-value is

0.024. It can be argued that holding more cash may slightly negatively affect the

performance in European companies, and the relation is meaningful at 2.5%

significant level. To be more precise, one unit of log cash may result in 0.0027

decrease in the ROA of the firm. Moreover, the coefficients of the three control

variables, which are Absorbed slack, Debt ratio and Capital intensity, are negative

and small numbers. All of the three coefficients are significant at the level of 1%. It

means the companies with higher slack, debt and capital intensity, will be possible

to have relative lower ROA. However, the table shows the coefficient for Size is

not significantly different from zero. It indicates that the size of a firm does not

have significant relationship with the corporation performance.

The regression result shows a negative relation between the cash holding and

performance, which is not in line with the hypothesis. It is possible to have

negative relationship since the excess cash may lead to overinvesting in less

profitable opportunities, increases entrenchment and results in poor corporate

governance (Nason, 2015). The reason of the different findings of this paper with

Nason and Patel’s paper can be explained by the difference between the Europe

and the U.S. market. In particular, Nason and Patel’s data are all from the

companies within one country, while in this paper, the 40 companies are randomly

selected from several European countries. The relationship may be affected due to

the different policies or currency conditions. In addition, according to Tson

Soderstrom (2003) the Europe Corporate Governance is still to be improved

compared with it of the United States, and this can be another reason for the

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different conclusion.

Table 3

Regression analysis 1

independentVariables Coefficient t-Statistic P-value

LogCash -0.0027 -2.26 0.024

AbsorbedSlack -0.0701 -21.77 0.000

DebtRatio -0.0295 -11.63 0.000

CapitalIntensity -0.0276 -12.42 0.000

Size 0.00064 0.44 0.660

_cons 0.0897 18.73 0.000

Observation 1998

F(5,1992) 137.69

R-squared 0.2898 This table reports the robust regression test results without the regression dummy.

Table 4 shows the results of the regression that includes the recession

dummy. It indicates the coefficient of the recession dummy multiplied by log cash

is 0.00059 and significant at 1% level. Precisely, one unit rise on log cash may

generate 0.00059 increasing in the ROA of the firm. This result suggests that

holding cash during that financial crisis period is not as bad as doing it when there

is no recession. However, cash holding may possibly help to increase ROA at some

level, which improves the overall performance. The result is in line with one of

Nason and Patel’s conclusions, which is during the recession period, it shows more

benefits for firms to hold cash. It draws the same conclusion as the previous

literature review in Chapter 2.3.

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Table 4

Regression analysis 2

independentVariables Coefficient t-Statistic P-value

LogCash -0.0025 -2.04 0.041

AbsorbedSlack -0.0695 -21.58 0.000

DebtRatio -0.0292 -11.49 0.000

CapitalIntensity -0.0274 -12.34 0.000

Size 0.00046 0.32 0.751

Recession*LogCash 0.00059 3.07 0.002

_cons 0.0885 18.49 0.000

Observation 1998

F(6,1991) 115.15

R-squared 0.2931 This table reports the robust regression test results with the regression dummy multiplied by log cash.

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Chapter 6: Conclusion

Analyzing the influences of cash holdings during the financial crisis is

important for both finance and strategy literature. Under recession, the choice to

hold or spend cash is salient; holding cash buffers a firm from threats, but spending

cash may allow firms to exploit new opportunities. The dilemma caused substantial

debate in public discourse (Nason, 2016).

In summary, the main aim of this thesis is to test the relationship between

the cash holding and the performance of the firm in Europe. It concludes that there

is a negative relation between the cash and the performance, but this relationship

may inverse and become positive during the recession time. It suggests that

holding excess cash may harm the company in Europe, but is possible to benefit

the company during the Financial crisis periods.

The limitation of this thesis is that the sample size is relatively small, it is

better to collect more data and generate more accrue results. Also, the control

variables in the model is limited, the further research should be completed with

finding more control variables that may affect the corporation performance.

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