Introduction | RDP 2016-03: Why Do Companies Hold Cash? (2024)

By international standards, Australian non-financial companies hold relatively high levels ofcurrency and deposits, or ‘cash’. Australian publicly listed companies rank secondwithin the Organisation for Economic Co-operation and Development (OECD) in their inclination tohold cash relative to other assets (Figure 1).

Sources:Authors' calculations; Compustat; Compustat Global

Company-level analysis indicates that Australia's relatively high OECD ranking persists evenwhen controlling for differences across countries in industry composition, average company size,growth, and earnings volatility. On this basis, Australia still ranks within the top five OECDcountries (Figure 2).

Notes:Based on conditional estimates from a regression with control variables that includesize, growth, earnings volatility, industry and year fixed effects; the estimates shownreflect the baseline industry, which is manufacturing, in the baseline year of 2014 andassuming a company of average size, growth, and earnings volatility; changes to thebaseline will change the average level of cash holdings, but not the relative ranking ofcountries

Sources:Authors' calculations; Compustat; Compustat Global

There has also been a secular rise in corporate cash in Australia over the past quarter century.The Australian Bureau of Statistics financial accounts indicate that, in aggregate, thecash-to-assets ratio (hereafter, ‘cash ratio’) for non-financial corporations rosefrom 9½ per cent in 1990 to 13½ per cent in 2015 (Figure 3).^[1] Company-levelanalysis indicates that the rise in cash has been broad-based across industries. Moreover, thetrend increase in corporate cash holdings in Australia has outpaced that of the OECD average.

Notes:Ratio to total assets (including fixed assets); cash includes: cash, government bonds,deposits and commercial paper

Sources:ABS; Authors' calculations

Despite Australia's international ranking in non-financial corporate cash holdings there hasbeen, to the best of our knowledge, little research into the reasons why Australian companieshold cash.^[2]According to Google Scholar, since 1990 there have been close to 10,000 research articlesrelated to ‘corporate cash’, but only a handful have studied Australiancompanies.^[3]

We aim to fill this gap in the existing literature by exploring the determinants of Australiancorporate cash holdings. We also explore why Australian corporate cash holdings have risen overtime and examine whether this rise has been ‘abnormal’ (in the sense that it cannotbe explained by fundamentals, such as company size, age and earnings volatility).

Following Keynes (1936), several corporate finance theories have developed to explain whycompanies hold cash. First, the ‘trade-off’ theory (Miller and Orr 1966) postulatesthat a company's optimal cash holdings are determined by the balance between the benefitsand costs of holding liquid assets when cash flows are uncertain. The benefits of holding cashinclude minimising the transaction costs associated with raising external funds or liquidatingassets (‘the transactions motive’) and being able tofinance projects in case other sources become too costly (‘the precautionary motive’).The main cost of holding cash is the opportunity cost of the money held in liquid assets.

Second, the ‘pecking order’ (or ‘financing hierarchy’) theory (Myers andMajluf 1984) states that to minimise asymmetric information costs, companies should financetheir investment first with internal cash then with debt and finally with equity. This theorysuggests that companies use cash as a buffer between retained earnings and investment needs.

Third, the ‘free cash flow’ (or ‘managerial excess’) theory (Jensen1986) argues that business managers are prone to pursue their own interest over the interests ofowners and creditors, and hence have an incentive to divert resources to activities thatpersonally benefit them. By holding cash, managers increase the amount of assets under theircontrol and gain discretionary power over the company's investment decisions.

We will refer to the first two theories under the broad heading of the ‘financingfrictions hypothesis’. Under both theories, companies hold cash as a buffer against beingfinancially constrained (either now or in the future). We will refer to the third theory asthe ‘agency costs hypothesis’.^[4]The financing frictions and agency costs hypotheses are not necessarily competing hypotheses; infact, the two hypotheses are perfectly compatible with each other. Our aim is to gauge theweight of evidence for each hypothesis in explaining why Australian companies hold cash.

These hypotheses are tested using longitudinal information on a large sample of both private andpublic companies from a database provided by Dun and Bradstreet (D&B). There are importantdifferences between private and public companies that are likely to help shed light on cashmanagement behaviour. Public companies can raise capital from the general public and can have anunlimited number of shareholders. In contrast, private companies cannot raise funds from thepublic because disclosure is required.^[5]The organisational differences between private and public companies are used to directly testthe two main hypotheses for holding cash:

1. Financing frictions hypothesis: public companies have greater access toexternal finance than private companies and should hold less cash, on average.
2. Agency costs hypothesis: public companies typically have greater separationof ownership and management than private companies and should hold more cash, onaverage.

To understand the determinants of the trend increase in cash holdings over the past quartercentury, we turn to a separate source of company-level information from Morningstar. We focus onpublicly listed companies as the existing evidence suggests that the rise in cash holdings hasbeen largely concentrated among publicly listed companies and long-run panel data are onlyavailable for listed companies.

Our main contribution to the existing literature is to provide the first detailed analysis ofwhy Australian companies hold cash. A large (and growing) body of international research hasanalysed the determinants of company cash holdings for the United States (Opler etal 1999; Dittmar and Mahrt-Smith 2007; Foley et al 2007; Harford, Mansiand Maxwell 2008; Bates, Kahle and Stulz 2009), the United Kingdom (Ozkan and Ozkan 2004), Japan(Pinkowitz and Williamson 2001), east Asia (Horioka and Terada-Hagiwara 2013) and Europe(Riddick and Whited 2009).

The rise in US corporate cash holdings has been described as a ‘puzzle’ (Pinkowitz,Stulz and Williamson 2013).^[6]But, as the international comparison suggests, Australian companies hold more cash than UScompanies, on average, and this has become increasingly apparent over time. So theAustralian ‘corporate cash puzzle’ seems worthy of investigation.^[7]

A common feature of the existing literature is a focus on publicly listed companies, largely dueto data availability. But the literature is increasingly examining the behaviour of public andprivate companies, as the necessary micro data become available. Recent studies have comparedthe cash management behaviour of public and private companies for the United States (Gao,Harford and Li 2013; Asker, Farre-Mensa and Ljungqvist 2011), the United Kingdom (Gogineni,Linn, and Yadav 2012) and Europe (Akguc and Choi 2013). We contribute to this expandingliterature by comparing the cash management behaviour of public and private companies inAustralia.

The other contribution of our paper is to provide an empirical assessment of the investment andfinancing decisions of private companies in Australia. Private companies are a large andunderexplored part of the Australian economy. In Australia, 99 out of 100 companies areprivately held and account for over 40 per cent of total corporate assets and sales and aboutone-third of corporate profits. By considering the behaviour of both public and privatecompanies, our results are likely to be representative of the corporate cash managementpractices of companies in the economy.

An understanding of corporate cash holdings is important from a policy perspective. First,increases in aggregate corporate cash holdings might be important for understanding the currentstate of corporate profitability, risk and growth. If companies have a precautionary savingmotive and are ‘hoarding’ cash rather than investing or paying out dividends, thenthis might be evidence that companies expect the economy to slow. Alternatively, if companieshave a speculative motive for holding cash, then an increase in cash might be evidence that somecompanies expect economic conditions to improve in the future.

Second, how companies allocate their financial resources is important to monetary policy to theextent that companies build up stockpiles of cash, which affect the transmission of balancesheet (and cash flow) shocks to corporate investment. We find evidence consistent with companiesholding cash to buffer against potential shocks. These precautionary holdings of cash might helpcompanies to avoid financing constraints and thereby lower the sensitivity of investment tomonetary policy shocks, though we leave such an investigation to future research.^[8]

To understand the policy implications of high cash holdings it is important to first understandwhy companies hold cash and to identify the extent to which those holdings of cash are ‘excessive’.This is our main focus; we leave a more detailed exploration of the links between monetarypolicy, interest rates and corporate cash to future research.

To preview our main results, we find that:

1. Public companies hold more cash, on average, than private companies, suggesting that agencycosts play some role in determining cash holdings.
2. The trend increase in the cash holdings of publicly listed companies can be largelyexplained by changes in observable company characteristics. In particular, relative to theircounterparts of 25 years ago, publicly listed companies today have better growthopportunities (as measured by Tobin's Q) and are more likely to operate in ‘risky’industries (with relatively high earnings volatility), and these characteristics arecorrelated with higher levels of corporate cash. This suggests that financing frictions areimportant too, and that some companies have precautionary and speculative motives forholding cash.
3. By historical standards, cash holdings of Australian publicly listed companies arenot ‘excessive’ after accounting for observable company characteristics.