Financial leverage and firm efficiency: the mediating role of cash holding

ABSTRACT

Agency cost theory suggests that a firm’s financial leverage is important to improve organizational efficiency. Using data of industrial companies of three biggest economies, this study analyzes how debt-financing decision affects firm efficiency and the mediating role of cash holding. We find inverted U-shape relationship between the level of financial leverage and firm efficiency. This implies that firms with optimum capital structure achieve high efficiency. The cash-holding level of the companies negatively relates to the efficiency. We also document that the firms’ that apply more financial leverage are less likely to hold excess cash balances and that the cash holding partially mediates the relationship between the financial leverage and the firms’ efficiency. This suggests that the use of debt financing has the potential to enhance firm efficiency by effectively tapping the free cash flow that would have been misused by the management. The results have important implications for corporate finance since it highlights how financial decisions determine corporate productivity.

KEYWORDS:

• Financial leverage
• cash holding
• firm efficiency
• agency cost theory

JEL CLASSIFICATION:

• G32
• M21
• D21

Disclosure statement

We declare that there is no conflict of interest to report.

Notes

¹ Estimating efficiency involves identifying the efficient frontier as a benchmark for measuring relative performance of the units. The relative efficiency score of a decision-making unit (DMU) is determined by how close it is to the efficient frontier.

Additional information

Funding

This paper is funded by the Natural Science Foundation of China (NSFC) grant number 71773025 and 71532004 and the National Key Research and Development Program of China (2020YFB1006104).