Andreas Joseph, Christiane Kneer, Neeltje van Horen and Jumana Saleheen
Financial crises affect firm growth not only in the short-run, but even more so in the long-run. Some firms permanently gain while others lose and cash is a crucial asset to have when the credit cycle turns. As we show in a new Staff Working Paper, having cash at hand allows firms to continue to invest during the crisis while industry rivals without cash have to divest. This gives cash-rich firms an important competitive edge that not only benefits them during the crisis but that gives them an advantage that lasts way beyond the crisis years.
But first, how are cash holdings – a firm’s deposit to asset ratio – actually distributed across sectors and firms? Figure 1 provides some insight. It looks at cash holdings just prior to the crisis, but these patterns have not changed much over time. Each dot represents an industry in the UK and shows how much cash firms in that industry have on average (horizontal axis) and how much these holdings vary within that industry (vertical axis). A striking fact stands out. Firms’ cash holdings not only differ greatly across but also within narrowly defined industries. This means that at any given moment in time some firms in an industry will have lots of cash at hand while others only very little.
Figure 1: Variations in cash holdings by industry (2006)
Notes: This figure plots the correlation between mean and standard deviation of the cash holdings of UK firms at the 4-digit industry level. Cash holdings are defined as deposits over total assets and measured in 2006.
Well, does this matter? Maybe not. When the economy is doing well firms’ cash holdings do not make much of a difference. This is roughly demonstrated in the top panel of Figure 2. Here we first rank firms in each industry according to the size of their cash holdings compared to other firms in that industry in the year 2000. Red means little cash compared to one’s industry rivals while green means lots of cash. Next, we track investment for these firms over time, i.e. the growth of their fixed assets, such as buildings, machines, office equipment, patents etc. Hardly any relationship between firms’ cash holdings and their investment between 2001 and 2007 exists: both cash-rich and cash-poor firms invested during this period. We now repeat this exercise, but measure cash in 2006 instead. That is, we rank firms according to the size of their cash holdings relative to their rivals just prior to the start of the global financial crisis. The picture changes dramatically as seen in the bottom panel of Figure 2. While firms with cash continued to invest throughout the crisis, cash-poor firms were shrinking their fixed assets. Perhaps more surprisingly, this divergence in investment behaviour became even more pronounced during the recovery period. Cash thus seems a crucial asset to have when the credit cycle turns.
Figure 2: Investment high vs low cash firms: pre-crisis and crisis period
Notes: These figures plot the average fixed asset growth for firms in each percentile of relative cash within the 90 percent interquartile range. In panel A average fixed asset growth is tracked over the period 2001-2007 and in panel B over the period 2007-2014. Fixed asset growth is defined as the log difference between 2001 and year 2001+j (pre-crisis period) and between 2007 and 2007+j (crisis period). Relative cash is calculated by subtracting from the firm’s cash holdings its industry mean and dividing the difference by the industry standard deviation and is measured in 2000 for the
pre-crisis period (panel A) and in 2006 for the crisis period (panel B). Industry mean and standard deviation are determined at 4-digit level.
Why does cash matter?
Keeping cash idle might be expensive during normal times, but when a financial crisis hits having cash at hand can positively affect firm investment for several reasons. First, cash provides a firm with an internal source of funds when earnings decline and it becomes more difficult to borrow from banks. Second, cash preserves its value when asset prices drop and can serve as high-quality collateral that a firm can pledge to raise external funds. Third, a firm with cash does not have to increase its cash holdings for precautionary reasons and can use its funds for investment instead.
Thus, firms with ample cash at hand can more easily continue to operate, replace fixed assets that have depreciated and even seize profitable investment opportunities when they come along despite the crisis. Their cash-starved rivals by contrast have to forgo investment opportunities, may be forced to shrink their fixed assets and may even struggle to survive. As a result, an investment gap between cash-rich and cash-poor firms opens up.
This brings about a shift in competition dynamics. As cash-rich firms grow their fixed assets their productive capacity expands. At the same time the productive capacity of cash-poor firms shrinks. During the recovery phase when demand returns and credit conditions improve, cash-rich firms have thus more capacity to meet this demand and can subsequently reinvest their earnings, increasing their capacity further. Cash-poor firms, on the other hand, have difficulties catching up with their cash-rich rivals and see their positions weaken further. As a result, the investment gap between cash-rich and cash-poor firms that opens up during a crisis period is amplified during the recovery period. This explains the growing divergence between “green” and “red” firms as observed in the bottom panel of Figure 2.
Who needs cash most?
While Figure 2 shows some very striking patterns, it is important to make sure that these differences are caused by differences in pre-crisis cash holdings and not by other factors. This is especially important as consumers reacted strongly to the crisis and were buying less products. In our analysis we therefore control for a large number of firm characteristics that might also explain how much a firm can invest when the credit cycle turns, as well as for economic conditions in the region where the firm is located and changes in demand and productivity affecting each industry. Even after accounting for all this, we find a strong cash effect.
In numbers, cash-rich firms grew their fixed assets with 4 percentage points more between 2007 and 2009 – the depth of the crisis – compared to their cash-starved industry rivals. By 2014 this number had tripled to 12 percentage points – a big difference. This effect was present both for firms whose cash holdings fluctuated a lot over time and for firms whose cash holdings were very stable. The cash-effect was unique to the crisis and post-crisis recovery period and was not present in the tranquil period that preceded the global financial crisis. This suggests that the tightening of credit conditions played an important role in driving the cash- effect.
So who benefits most? Not surprisingly, it’s the young and small firms. During a financial crisis banks are more likely to cut lending to young and small firms. Having access to cash should thus be especially advantageous for these firms. Indeed, we find that a young firm (a business that is less than 10 years old) with cash invested 15 percentage points more over the period 2007-2014 than a young firm without cash and a small firm with cash 19 percentage points more than a small firm without cash.
As an illustrative example, let’s compare two hypothetical small coffee shops somewhere in the UK with different cash holdings before the start of the crisis. Let’s say that both have equipment, such as coffee machines, grinders, furniture, computers etc., worth £100,000. Using our estimates, the coffee shop with high levels of cash will, by 2014, have grown its equipment to the value of roughly £110,000, while the cash-poor shop’s equipment will only be worth just over £90,000. In other words, the cash-rich business owner could replace its coffee machines with the latest models and even buy and extra machine and expand the business. The other one instead had to scale down and keep old machines running for longer. Which one would you more likely go to for your morning latte? Very likely, the first one.
Indeed, we find that cash-rich firms, especially the young and small ones, were able to capture market share from their cash-poor rivals during the crisis and even more so during the recovery phase. And these firms were also able to generate greater profits over time. When you have more and better coffee machines, you are able to serve more customers and can poach them from your competitors.
A financial crisis not only impacts firms in the short-run, but also in the long-run as some firms permanently gain while others permanently lose. Having cash at the onset of a crisis gives a firm an important competitive edge during the crisis that it can further exploit during the recovery phase. A liquid balance sheet when the credit cycle turns is thus an important determinant of firms’ long-term growth after a crisis – and a factor largely neglected by economists and policy makers.
Andreas Joseph works in the Bank’s Advanced Analytics Division, Christiane Kneer works in the Bank’s Financial Stability Strategy and Risk Division, Neeltje van Horen works in the Bank’s Research Hub and Jumana Saleheen works at the CRU Group.
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