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How firms manage their cash flows: an examination of diversification’s effect

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Abstract

We extend recently documented evidence that diversified firms hold significantly less cash than specialized firms to consider differences in how diversified and specialized firms adjust their cash flows to achieve their target cash balance. We find that diversified firms have higher free cash flows as a result of equal operating cash flows and lower investment in comparison to specialized firms. Diversified firms save less cash by placing less reliance on external financing; by issuing less debt and equity, and distributing higher cash dividends. Our findings support the hypothesis that diversified firms are able to hold less precautionary cash as they are in better position to finance investment opportunities internally from operating cash flows.

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Notes

  1. Lewellen (1971) argues that imperfect correlations between divisions’ cash flows may increase debt capacity by reducing default risk. Stulz (1990) provides a theoretical model in which lower cash flow volatility due to diversifications may reduce information asymmetry between managers and shareholders and consequently moderate frictions in issuing equity.

  2. Hadlock et al. (2001) empirically support the argument by showing that equity issues by diversified firms are viewed less negatively than those of specialized firms.

  3. Dimitrov and Tice (2006) and Peyer (2002) provide empirical evidence supporting this argument.

  4. Denis and Sibilkov (2010) set out an extreme scenario in which firms with low cash flow and limited access to external finance are forced to have less cash as they are unable to accumulate cash reserves and/or are forced to drain previously accumulated cash reserves. However this is less likely the case for diversified firms, who we expect to have greater access to external capital markets given their lower risk and larger asset base.

  5. Under the pecking order model of Myers (1984), given the higher cost of external financing relative to internal financial resources, firms will choose to fund all projects using available internal finance before accessing to progressing to external financing sources. Empirical evidence of the negative relation between internal and external financing is provided in Shyam-Sunder and Myers (1999) and Acharya et al. (2007).

  6. In an unreported analysis, we confirm the finding of a negative relation between cash holdings and corporate diversification in a regression analysis after controlling for a series of variables outlined in Opler et al. (1999).

  7. Our unreported analysis shows that average ratio of net cash flows to total assets in specialized firms is larger than diversified firms in 17 out of 20 years during the period 1990–2009. Additionally, during this 20 year period, net cash flow is positive in 18 years for specialized firms and 17 years for diversified firms.

  8. The finding that specialized firms repurchase more shares than diversified firms is consistent with arguments made in several studies on payout policy (see Jagannathan et al. 2000). Stock repurchases are viewed as a more suitable way to distribute profits in firms with less stable earning streams.

  9. Our results are unchanged if we define large firms as those with book value of assets above the sample median.

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Acknowledgments

We thank Anna Danielova, Andrew Marshall, Isaac Tabner, seminar participants at the University of Stirling, as well as participants at the 4th International Accounting and Finance Doctoral Symposium, and the 2015 Financial Management Association annual meeting for their helpful comments and suggestions on earlier versions of this paper.

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Authors and Affiliations

  1. Portsmouth Business School, University of Portsmouth, Portsmouth, UK

    Thang Nguyen

  2. Leeds University Business School, University of Leeds, Leeds, UK

    Charlie X. Cai

  3. Department of Accounting and Finance, University of Strathclyde, Glasgow, G4 0QU, UK

    Patrick McColgan

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  1. Thang Nguyen
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  2. Charlie X. Cai
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  3. Patrick McColgan
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Correspondence to Patrick McColgan.

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Nguyen, T., Cai, C.X. & McColgan, P. How firms manage their cash flows: an examination of diversification’s effect. Rev Quant Finan Acc 48, 701–724 (2017). https://doi.org/10.1007/s11156-016-0565-1

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