Operating leverage and corporate cash holdings: evidence from China

ABSTRACT

This study examines the effect of operating leverage on firms’ cash holdings. We find that operating leverage can effectively increase corporate cash holdings. This effect is more pronounced among the firms with higher operating risks and asset specificity, indicating that operating risks and adjustment costs are two critical channels through which operating leverage increases cash holdings. The positive effect of operating leverage on firm’s cash holdings is only significant among the firms whose sales revenue grows discontinuously and rejects the alternative explanation. Our further study identifies that operating leverage can enhance the positive effect of cash holdings on firm value.

KEYWORDS:

• Cash holdings
• operating leverage
• operating risk
• adjustment cost

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. Operating leverage (OL) is calculated by the following formula: OL= Total Contribution Margin /EBIT= (EBIT + Fixed Cost)/EBIT =1+ (Fixed Cost/EBIT). Therefore, a higher ratio of fixed costs to EBIT implies a higher operating leverage of the firm.

2. Our research samples show that the proportion of firms with sales growth during the sample years was as high as 70.46%; however, the proportion of firms with sales growth fell to 52.57% for 2 consecutive years, and 40.37% for 3 consecutive years. It can be seen that for individual firms, the realization of continuous growth of sales has great uncertainty.

3. The non-cash costs in fixed costs, such as depreciation of fixed assets and amortization of intangible assets, will affect the firm’s current profits, but will not affect the firm’s current cash flow. Therefore, if a firm’s fixed costs include a large amount of non-cash costs, even if the firm’s operating leverage is high, it will not cause large fluctuations in cash flow, and thus will not have an important impact on the firm’s cash holding decision.

4. See Aboody, Levi, and Weiss (2018) for the details on derivation process (page 429) which explains the appropriateness of (1-β) to measure operating leverage by giving some examples.

5. The variable TREAT alone has been absorbed in the firm-level fixed effects and the variable POST alone has been absorbed in the year-level fixed effects, thus TREAT and POST alone are not presented in Table 4.

6. We thank the referee for suggesting this potential endogeneity problem.

Additional information

Funding

This work was supported by the National Natural Science Foundation of China under Grant number [71872175] and The Capital Market Research Centre of Southern Jiangsu Province in China under Grant number [2017ZSJD020].