While most Americans have spent down their pandemic savings, non-banking U.S. firms have increased their hoards of cash, reaching $6.9 trillion, an amount larger than the GDP of all but two countries. Even as interest rates have risen, cash now represents $1 out of every $5 of total assets held by non-banking U.S. firms, according to our research.
Why would U.S. firms hold so much in an asset class that yields far lower returns than their cost of borrowing? Researchers have offered multiple explanations, including flexibility and taxes, which we review below. But our work adds another explanation that we call “precautionary cash holdings.”
In short, companies hold cash because it helps them avoid premature failures that decimate shareholder value.
Reasons for Holding Excess Cash
Prior research has established three main reasons why firms hold large amounts of cash.
Investment and operational flexibility
With the growing knowledge economy, firms need agility to gain first-mover advantages, and must be able to scale operations rapidly to earn winner-takes-all reward structure. In order to exploit such now-or-never opportunities, firms face a challenge of either timing their profits with their investment needs, or instantaneously raising cash with new equity shares or bank borrowings. Neither is feasible. Forecasting is difficult, banks take time to take loan decisions, and public equity markets have prolonged legal and regulatory requirements. Cash provides a cushion to bridge the timing mismatch between cash generation and sudden cash needs. It gives firms the flexibility to quickly capitalize on a profitable opportunity.
Managerial opportunism
An influential stream of research argues that holding excess cash appeals to executives who aspire to “empire building.” According to this line of thinking, managers hoard excess cash to indulge in unprofitable acquisitions and unnecessary diversifications that may further executives’ clout at the expense of shareholders. In essence, executives dream of being Bob Iger at Disney or the fictional Logan Roy in Succession — and having cash on hand makes it easier to pull off big deals.
Multinational tax savings
A 2020 HBR article describes how multinationals operating with knowledge-based business models have greater flexibility to move profits from high-tax-rate to low-tax-rate countries using transfer pricing schemes. For example, governments can easily trace where car parts were manufactured, where the car was assembled and sold, and what the profit margin was. It’s difficult, however, to ascertain profits margins and locations of profit generation in knowledge-intensive businesses. The most significant cost for doing knowledge-based businesses is the development of intellectual property, whose costs, through royalty and license payments, can be easily shifted to a tax haven with a stroke of a pen, as we previously showed.
Even as tax rules have changed over time, the downside of these tax-saving schemes remain that the profits must be continually parked abroad, because they become taxable when they are brought back to the U.S. The cash keeps accumulating. Apple once famously borrowed money to pay dividends to its shareholders, while it was sitting on mountains of cash parked in tax haven countries. In this view, companies hold excess cash largely to avoid having it taxed through repatriation.
Our Research: Precautionary Cash Holdings
Our study offers a new reason for holding cash. We examine the impact of firm’s cash holding on the likelihood of firm’s delisting from stock exchange. We focus on delistings that occur for adverse events that can rapidly drain out cash reserves and can cause firm failure, such as supply chain disruptions, labor strikes, port closures, lockouts, customer demand changes, customer defaults, technology disruptions, product obsolescence, regulation changes, and international wars. We ignore delistings for good reasons, such as going private or being acquired by another company. The types of delistings we examine destroy shareholder wealth because shareholders no longer have avenues to trade their shares and are left with worthless pieces of paper.
We use data on about 4,600 delisting events of the U.S. public corporations, from 1986 to 2021, from Center for Research in Security Prices. We also obtain financial data on about 148,500 firm-years from Wharton Research Data Services. We find that on average, 3% of firms get delisted ever year. After controlling for factors known to affect the delisting likelihood, we find that a 10% increase in firm’s cash holdings is associated with a 5% decrease in the likelihood of delisting, on average, that is, by 0.15%. We interpret this correlation as evidence that cash reserves act like insurance against sudden economic shocks — including delisting.
More important, our research helps quantify the insurance effect of cash for different types of firms. Smaller firms (lowest 20% by market value), firms with high current liabilities (highest 20% as a percentage of assets), and firms prone to frequent business shocks (with the highest 20% of idiosyncratic stock-return volatility) have a 10% likelihood of delisting per year, about four times higher than the rest of the firm population. In each case, they need about a 25% increase in cash holdings to reduce their delisting likelihood by 5% of their base likelihood rates, that is, by just 0.5 percentage points. To decrease their delisting likelihood by half, to 5% a year, they would need to increase their cash holdings by as much as 2.5 times. Stated differently, in order to bring down their delisting likelihood anywhere close to that of the large and stable companies, they would need a substantial infusion of cash.
Our results suggests that precautionary or insurance reasons can explain almost all cash holdings of small and vulnerable firms. And we suspect this explanation is becoming more important as innovation and R&D investments are increasingly the main drivers of success for U.S. corporations. Knowledge firms typically have high cash burn rates and must initially incur losses to succeed. But they have little collateral capacity, shrinking they ability to borrow. Hence, they must keep cash to manage uncertainty, especially with knowledge-based business models.
Viewed in this light, cash holdings, at least for small and vulnerable firms, should not be construed as a surplus asset. Rather, it should be considered an operating asset, like inventory or an office building, necessary to ensure the smooth working of the company.
Implications for Boards and Managers
There is no one-size-fits-all formula for determining optimal cash holding. Managers must thus thoroughly understand their business model and its distinctive characteristics, its risks and opportunities, and accordingly estimate the optimal cash holdings.
In contrast to planning for resources, such as manpower, inventory, and machine requirements, that are based on projecting the most likely outcomes of the future scenarios, cash requirements must be assessed based on extreme points of expected outcomes, both good and bad. And since investors — especially activist shareholders — look suspiciously at firms’ large cash holdings, executives must effectively communicate with shareholders to explain the insurance benefit of their cash holdings.
U.S. firms now hold large amounts of cash, amounting to almost 20% of their total assets. While there are concerns that such large cash holdings yield little and can lead to inefficient investment decisions, our research suggests that large cash holdings are required to address the changing business environment and evolving business models.
Nevertheless, managers must dynamically assess their circumstances, and board of directors must remain vigilant, to protect the firm and shareholder interests through optimal cash holdings. This aspect has become especially important with the rising interest rates, constrained supply of credit, and recent bank turmoil.
