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Financial Strength and Product Market Behavior

By Harvard Law School Program on Corporate Governance

Seldom has corporate strategy been turned on its head so quickly. Not long ago, cash holdings were considered a dangerous thing to accumulate and companies that hoarded large cash positions were viewed with a great deal of suspicion. However, the recent market turmoil and the resultant tightening of credit have clearly emphasized the advantage of maintaining a liquid balance sheet, as many firms are desperately seeking to avoid a cash squeeze. This rapidly changing perspective underscores the need for a deeper understanding of what the implications of corporate cash policy really are. Indeed, although recent developments have considerably broadened our knowledge of the various determinants of corporate cash holdings, the literature has so far paid little attention to whether cash holdings have a material effect on firms? day-to-day operations. My paper, Financial Strength and Product Market Behavior: The Real Effects of Corporate Cash Holdings, forthcoming in the Journal of Finance, helps bridge that gap by examining whether cash holdings include a strategic dimension that affects firms? product market decisions.

Theory predicts that cash holdings may have both direct and indirect effects on competitive outcomes. On this ground I argue that irrespective of the mechanism at work, if cash holdings influence product market outcomes, then we should observe cash-rich firms gaining market share at the expense of their competitors. However, because a firm?s cash policy may be endogenously related to its product market performance, establishing a causal link going from cash holdings to product market outcomes is a difficult task. In this paper I use two different empirical strategies to side-step this identification challenge.

First, I use asset tangibility to force the exogenous portion of cash to explain market share growth. While a firm?s asset tangibility correlates with its cash reserves, there is little reason to believe that the tangible attributes of a firm?s assets have a direct influence on its product market performance other than through its association with financing ability. Based on firm-level data from a panel of 105 well-defined product markets, instrumental variables estimates provide strong evidence that a firm?s stock of cash is associated with future market share expansion at the expense of industry rivals. More specifically, firms with noticeably higher cash reserves expand their market shares relatively more than their competitors in future years. The estimates reveal an economically important cash effect. Across all industries, a one-standard deviation increase in relative-to-rivals cash holdings allows the average firm to realize a 2.9% increase in its product market share over the next two years.

Second, to further mitigate concerns that product market performance drives observed cash levels, I exploit exogenous variation in industry-level import tariffs as a quasi-natural experiment. Since the softening of trade barriers substantially increases the competitive pressure from foreign rivals, large reductions in import tariffs represent situations in which firms have to use their pre-existing cash positions to compete in an unexpectedly modified product market environment. Difference-in-difference regressions confirm the positive impact of cash on market share growth. Firms with more cash on hand perform significantly better when their industry experiences an exogenous intensification of product market competition.

To cement the validity of my interpretation, I offer evidence that the estimates truly reflect the positive impact of cash reserves on product market performance rather than biases due to the potentially unspecified effect of debt ratios. I uncover a substantial impact of cash on market share growth, even when cash is markedly distinct from negative debt. This analysis highlights that the competitive effect of cash is not the flip side of the well-documented effect of debt ratios. This is an important result given the extensive literature documenting a connection between debt and product markets, as well as the conventional view that cash is the negative of debt.

Next, I take advantage of the cross-industry nature of the sample to investigate how the effect of cash holdings on competitive performance depends on industry characteristics. In particular, I explore how rivals? financial status alters the competitive effect of cash holdings. Consistent with the idea that a cash surplus confers a strategic advantage over cash-poor rivals, I observe that the cash-performance sensitivity is magnified when rivals have weak financial positions. In a similar vein, I investigate the extent to which the competitive effect of cash is determined by the quantity of strategic interactions between firms within their industry. The evidence points to noticeable differential effects. In particular, the effect of cash on market share growth turns out to be twice as large in competitive markets as in concentrated markets. Moreover, the larger the interdependence of firm growth prospects among industry rivals, the greater the effect of cash. In the same way, product market performance is more sensitive to cash in sectors in which foreign competition is substantial or when a firm operates in the technological core of its industry. Consistent with a strategic dimension, the impact of cash holdings on product market performance appears to be related to rivals? financial condition as well as to the intensity of strategic interactions within product markets.

Finally, I examine the impact of relative cash reserves on firm value and operating performance. Using various specifications, I show that firms with large cash reserves experience increases in both market value and return on assets in comparison with their cash-poor rivals. This result, which is robust to the inclusion of several controls for investment opportunities, suggests that the competitive effect of cash is value enhancing.

This paper makes two main contributions to the literature. First, by providing evidence that cash policy comprises a substantial product market dimension, it deepens our understanding of the implications of cash holdings. Second, this study complements recent papers that document a negative association between debt ratios and product market performance. This result is typically interpreted as evidence that highly indebted firms are financially fragile and thus can be severely affected by rivals? competitive strategies. By establishing an independent link between cash holdings and product market outcomes, the results in this paper point to an additional channel through which finance affects product market behavior.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on January 27, 2010 (boomark / email).