Abstract
Prior literature has studied the relationship between historic cash flow volatility and current levels of liquidity (Bates et al. in J Financ 64:1985–2021, 2009; Han and Qiu in J Corp Financ 13:43–57, 2007). In this paper, we study the relationship between liquidity and future returns. When investors observe a highly liquid balance sheet, they infer the firm’s beliefs about the risk of future cash flow volatility and price the stock accordingly. Our measure of liquidity is negatively and significantly associated with subsequent period stock returns. More liquid firms earn significantly higher levels of returns over the subsequent period, consistent with investor perceptions that liquidity is positively associated with future cash flow risk. We also find that firms with highly liquid balance sheets also realize significantly higher levels of future cash flow volatility, consistent with precautionary savings. This represents one possible explanation for why investors perceive more liquid firms as riskier than their less liquid counterparts.
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Data availability
The data that support the findings of this study are available in Wharton Research Data Services at http://wrds-www.wharton.upenn.edu.
Code availability
All analysis for this study was performed in STATA. The code generated during and analyzed during the current study is available from the corresponding author on reasonable request.
Notes
Myers and Majluf (1984) conclude that firms in need of capital will use internal financing as a first resort and external financing as a second resort. Internal financing comes from retained earnings, while external financing comes from the issuance of debt or equity. Internal financing is generally less costly to a firm because outside investors, such as debtors or bondholders, have less information about the firm. The information asymmetry between the firm and these outside investors can impact the cost of capital.
These items are: cash and cash equivalents (CHE), receivables (RECT), inventory (INVT), other current assets (ACO), other investments (IVAO), investments in equity (IVAEQ), property, plant, and equipment (PPENT), intangibles and goodwill (INTAN), and other assets (AO).
For each line-item, firms vary in terms of relative liquidity. For example, some firms have very liquid property, plant, and equipment while others have very illiquid property plant and equipment.
Our results are robust to relaxing this assumption to one, two, three, or four years of survivorship. For each of these relaxed assumptions, our value-weighted portfolio spread and five-factor alphas remain statistically significant.
For the purposes of these regressions, we define cash flow following Bates et al. (2009) as earnings before interest and tax plus depreciation less interest expense and common dividends. However, we have also controlled for operating cash flow (OANCF) scaled by total assets, and our results are qualitatively similar. The use of operating cash flow truncates our sample period because the Financial Accounting Standards Board first required the Statement of Cash Flows in 1988.
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We thank the anonymous referees and participants at the 2020 AAA Spark Meeting for their helpful comments
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The authors would like to thank Ball State University and the University of Dayton for generous financial support.
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Appendix A
Appendix A
This appendix details the construction of all variables used throughout the paper. We have recorded Compustat abbreviations parenthetically as appropriate.
Liquidity | Liquidity is defined by Eq. (1) and is calculated as cash (CHE) times 1 plus receivables (RECT) times two plus inventory (INVT) times three plus other current assets (ACO) times four plus property, plant, and equipment (PPENT) times five plus other investments (IVAEQ) times six plus investments in equity (IVAO) times seven plus intangibles (INTAN) times eight plus other assets (AO) times nine scaled by 45 times lagged total assets |
GKP weighted asset liquidity 1 | GKP Weighted Asset Liquidity 1 is cash (CHE) scaled by lagged total assets (AT) |
GKP weighted asset liquidity 2 | GKP Weighted Asset Liquidity 2 is cash (CHE) scaled by lagged total assets (AT) plus one-half times total current assets (ACT) less cash (CHE) scaled by lagged total assets (AT) |
GKP weighted asset liquidity 3 | GKP Weighted Asset Liquidity 3 is cash (CHE) scaled by lagged total assets (AT) plus three quarters times total current assets (ACT) less cash (CHE) scaled by lagged total assets (AT) plus one-half times total assets minus total current assets minus intangible assets scaled by lagged total assets (AT) |
Cash flow | Cash flow is defined following Bates, Kahle, and Stulz (2009) as earnings before interest and tax (EBIT) plus depreciation (DP) minus interest expense (XINT) minus common dividends (DVC) scaled by total assets (AT) |
Historic cash flow volatility | Historic cash flow volatility is calculated as the standard deviation of cash flow over the years t − 10 to t − 1. We require a minimum of three cash flow observations for inclusion in the sample. This measure is consistent with Bates et al. (2009) |
Industry cash flow volatility | Industry cash flow volatility is the average cash flow volatility by industry and year. We define industry by two-digit SIC code. This measure is consistent with Bates et al. (2009) |
Future cash flow volatility | Future cash flow volatility is calculated as the standard deviation of cash flow over the years t + 1 to t + 10. We require a minimum of three cash flow observations for inclusion in the sample |
Market-to-book | Market-to-Book, for the cashflow volatility regressions, is the market capitalization scaled by the book equity of the firm. We define this as common shares outstanding (CSHO) multiplied by the price at the end of the fiscal year (PRCC_F). For the Fama–MacBeth regressions, market capitalization is defined as the common shares outstanding at the end of June of year t multiplied by the price at the end of June of year t |
Real size | Real Size is the natural log of total assets (AT) |
Capital expenditures | Capital expenditures is the total capital investments (CAPX) made in the year scaled by lagged total assets (AT) |
Cash ratio | Cash Ratio is defined as the cash and cash equivalents (CHE) divided by total assets (AT) |
Change in cash ratio | Change in Cash Ratio is defined as the difference between the cash ratio in the current year and the cash ratio in the prior year |
R&D to sales | R&D to Sales is defined as the research and development (XRD) cost scaled by total sales (SALE). We replace missing values of research and development (XRD) with zero |
Net working capital | Net Working Capital is defined as the total current assets (ACT) minus total current liabilities (LCT) scaled by total assets (AT) |
Leverage | Leverage is defined as the long-term debt (DLTT) plus total current liabilities (LCT) scaled by total assets (AT) |
Size | Size is defined as the market capitalization of the firm at portfolio formation, which is the price at the end of June of year t multiplied by the shares outstanding at the end of June of year t |
Return on assets | Return on Assets is earnings before interest and taxes (EBIT) scaled by lagged total assets (AT) |
Momentum | Momentum is the compound returns from month t − 12 to month t − 1 |
O-score | O-score is calculated similar to Ohlson (1980) and is calculated as follows for firm i in year t: \(\begin{aligned} O - Score_{i,t} = & - 1.32 - 0.407 \times \log \left( {\frac{{TA_{i,t} }}{GNP}} \right) + 6.03 \times \frac{{TL_{i,t} }}{{TA_{i,t} }} - 1.43 \\ & \times \frac{{CL_{i,t} }}{{CA_{i,t} }} - 1.72 \times High_{i,t} - 2.37 \times \frac{{NI_{i,t} }}{{TA_{i,t} }} - 1.83 \\ & \times \frac{{FFO_{i,t} }}{{TL_{i,t} }} + 0.285 \times Loss_{i,t} - 0.521\frac{{NI_{i,t} - NI_{i,t - 1} }}{{|NI_{i,t} \left| { + |NI_{i,t - 1} } \right|}} \\ \end{aligned}\) where (Compustat data item listed parenthetically): TA = Total Assets (AT) GNP = Gross Nation Product Index Level Year = 2012 TL = Total Liabilities (TL) WC = Working Capital (ACT-LCT) CL = Current Liabilities (LCT) CA = Current Assets (ACT) High = 1 if total liabilities (LT) exceed total assets (AT), and 0 otherwise FFO = Cash Flow from Operations (OANCF) Loss = 1 for firms with negative net income (NI) in the prior two fiscal years, and 0 otherwise |
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Angelo, B., Johnston, M. Do investors infer future cash flow volatility based on liquidity?. Rev Quant Finan Acc 60, 259–294 (2023). https://doi.org/10.1007/s11156-022-01094-4
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DOI: https://doi.org/10.1007/s11156-022-01094-4