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Financial
Financial flexibility and the flexibility
performance during the recent
financial crisis
79
Iwan Meier
Department of Finance, HEC Montreal, Montreal, Canada, and
Yves Bozec and Claude Laurin
Department of Accounting, HEC Montreal, Montreal, Canada

Abstract
Purpose – The objective of this study is to test whether financial flexibility has value. Using the
current financial crisis, the authors investigate whether firms that built up financial flexibility over the
years preceding the crisis yield superior performance during the financial crisis.
Design/methodology/approach – Financial flexibility is measured along the following
dimensions: cash and cash equivalents, debt (short-term and total) and net debt. These proxies are
measured as an average over the five years prior to the crisis, from September 2002 to August 2007.
Firms are then sorted into ten portfolios and monthly stock returns for each portfolio are evaluated
over the crisis period from September 2007 to March 2010.
Findings – The authors’ results show that high pre-crisis levels of cash do not seem to have a positive
impact on firm value during the crisis. However, the results provide evidence that high pre-crisis levels
of debt had a negative impact on firm value during the latest financial crisis, supporting the hypothesis
that financial flexibility has value.
Originality/value – The originality of the authors’ approach is to evaluate the value of financial
flexibility during a financial crisis. The recent financial crisis offers an ideal test case to evaluate
whether financial flexibility has indeed value for the firm.
Keywords Financial flexibility, Financial crisis, Stock performance, Cash holdings, Flexibility, Stocks,
Cash
Paper type Research paper

I. Introduction
Microsoft and Google have at least one thing in common: they have virtually no debt
and hold large cash positions. Google has a market capitalization of $116 billion (at the
beginning of March 2009), cash holdings of $16 billion, and no debt. Microsoft with a
market capitalization of $172 billion holds $20 billion in cash and a mere $2 billion debt
position[1]. These two examples are not exceptions. In fact, Strebulaev and Yang (2006)
report that, over the time period from 1987 to 2003, 11 percent of the publicly traded
non-financial US firms do not have any debt and 29 percent have less than 5 percent
debt. When considering net debt positions, defined as debt minus cash holdings,
an astounding 36 percent of publicly traded non-financials have zero or negative net
debt.
Firms having no debt and holding large cash positions are difficult to reconcile with International Journal of Commerce
any of the two major theories on the optimal choice of debt versus equity, i.e. a firm’s and Management
Vol. 23 No. 2, 2013
capital structure. First, the static tradeoff theory is based on the fact that debt offers tax pp. 79-96
q Emerald Group Publishing Limited
savings because interest payments are tax deductible. This theory suggests that firms 1056-9219
should use debt up to the point where the tax advantage of debt and the disadvantage DOI 10.1108/10569211311324894
IJCOMA of debt in form of costs of a potential bankruptcy balance out. Graham (2000) studies
23,2 the tax advantages of debt and concludes that the low average debt-equity ratios of US
firms are puzzling[2].
Second, the pecking order theory put forward by Myers (1984) and Myers and Majluf
(1984) predicts (based on asymmetric information arguments) that firms prefer
financing their investments by cash, then debt, and as a last resort they would issue
80 equity. This would result in low cash balances and high levels of debt[3].
These two main capital structure theories are an integral part of any course syllabus
or textbook chapter on capital structure. However, these theories fail to explain the
widespread existence of no debt (and very low debt) firms. In addition, Opler et al. (1999)
and Hartford (1999) point out that also the observed accumulated cash balances of firms
appear too large to be in line with existing theories.
The low debt ratios and significant cash balances do not imply that the tradeoff
theory or the pecking order theory is not valid. However, they indicate that these theories
alone cannot explain the cross-section of capital structures that we observe. When
asking financial managers directly using surveys, Graham and Harvey (2001) and
Jagannathan et al. (2011) for the USA, and Bancel and Mittoo (2004) and Brounen et al.
(2004) for European firms, find that managers rank financial flexibility as being a very
important consideration when deciding on the optimal debt-equity mix. This is consistent
with the findings of Minton and Wruck (2001) who analyze balance sheet and income
statement data and conclude that firms “stockpile financial slack and/or debt capacity”.
Hence, it appears that firms have a desire for financial flexibility in order to be in a
position to seize future investment opportunities. In this study, we focus on financial
flexibility in the form of high cash balances and low debt levels[4]. Firms that hold
substantial cash reserves or keep their debt levels below their borrowing capacity have
the flexibility to fund new profitable projects without the need to raise money externally
through debt or equity issues. In contrast, a firm with no excess cash and borrowing at
its limit may have difficulty to raise equity in turbulent market conditions in order to
finance such a profitable opportunity. The recent financial crisis offers an ideal test case
to evaluate whether financial flexibility has indeed value for the firm. We would expect
that a financial crisis with constrained access to financing sources is exactly the
situation where a firm should benefit from accumulated financial flexibility. Our
hypothesis is that (risk-adjusted) stock returns of firms with high degrees of financial
flexibility should outperform their peers during the recent financial crisis[5]. If firms
with financial flexibility fare better in rough times, we would conclude that financial
flexibility has value. This would provide an, at least partial, answer to the puzzle why
many firms deviate substantially from the predictions of the tradeoff or pecking order
theory by holding much less debt than expected. We therefore propose to test whether
firms that built up financial flexibility over the years preceding the financial crisis yield
superior performance during the recent turbulent period on financial markets.
We find that pre-crisis high levels of cash do not seem to have a positive impact on
firm value during the latest financial crisis. However, our results provide evidence that
pre-crisis high levels of debt had a negative impact on value during the crisis,
supporting the hypothesis that financial flexibility has value. This result is especially
true for industries where cash flows are more volatile.
The article is organized as follows. Section 2 presents the theory and literature on
the link between capital structure and firm performance. Section 3 describes the
methodology including data, sample selection, and empirical model. Section 4 presents Financial
the results and Section 5 concludes. flexibility
II. Theory and literature
2.1 Optimal capital structure
The financing decision is a key question in corporate finance. The empirical evidence
on the use of internally available cash, debt, or equity issues (or a combination of these 81
sources of financing) appears to be hardly in line with existing theories.
Much has been said about Modigliani and Miller’s (1958) famous “capital structure
irrelevance principle”, according to which, in the absence of tax and bankruptcy costs
and assuming efficient markets, firms should be indifferent with respect to their choice
of financing source. It is also well known that in the presence of taxes firms are
expected to use debt as their primary source of financing, because interests are tax
deductible according to tax laws while dividends are not. Hence, mainly due to tax
advantages, issuing debt should be preferred to raising equity.
Modigliani and Miller’s famous argument does not explain why a certain number of
firms continue to hold substantial cash reserves and have low or no debt. In an attempt to
explain why cash reserves could have value, Gamba and Triantis (2008) argue that
because such reserves help firms to prevent default in low profitability states, firms
could benefit from holding reserves in financially difficult times. They further argue that
holding cash reserves enable firms to benefit from short-lived investment opportunities.
Therefore, they conclude that young firms with low profitability could see advantages in
holding cash reserves. Opler et al. (1999) argue, along the same lines, that the flexibility
granted to firms by excess cash is valuable. They show that risky firms, i.e. firms with
potentially high transaction costs, hold higher ratios of cash to non-cash assets. But
somewhat surprisingly, their empirical results show that healthy and financially
performing firms also tend to accumulate cash at levels that are higher than what static
tradeoff models would suggest.
In fact, these studies are part of a large number of studies which document that a
significant number of well performing firms choose to hold high cash reserves.
Firms such as Microsoft and Google hold substantial amounts of cash and have
insignificant amounts of debt. More than a random effect, zero-debt levels appear to
be quite sustainable over time. Strebulaev and Yang (2006) show that zero-debt levels
are maintained through a period of more than five years for close to a third of the
zero-leverage firms in their sample.
Other studies show that the estimated tax savings associated with debt holdings are
left largely unexploited (Graham, 2000). Furthermore, the pecking order theory, which
formalizes the conventional wisdom according to which debt issues should track firms
financial deficit, does not withstand the test of reality. This latter fact has lead Fama
and French (2005) to argue that “[. . .] the pecking order, as the stand alone model of
capital structure proposed by Myers (1984), is dead”.
In short, the empirical evidence tends to show that capital structure indifference and
the pecking order theory do not explain why a significant number of firms choose to hold
substantial cash reserves and no debt. The evidence collected so far indicates that
managers’ desire for financial flexibility is real ( Jagannathan et al., 2011; Bancel and
Mittoo, 2004; Brounen et al., 2004; Graham and Harvey, 2001). By accumulating financial
flexibility, firms are well positioned to seize investment opportunities. In this article,
IJCOMA we argue that financial flexibility has value and that this value is likely to be more
23,2 evident in difficult financial times. Using the historical financial crises of 2007-2009 as an
opportunity to test our prediction, we provide evidence on the links between measures of
financial flexibility and firm value.

2.2 The value of financial flexibility in a financial market crisis

82 The subprime mortgages crisis that began in August 2007 and the banking panic that
followed in the fall of 2008 have created one of the most severe financial markets crises.
As a result, non-financial firms’ access to capital has been limited. Ivashina and
Scharfstein (2009), for instance, document a significant drop in bank lending during
this period. They find that new loans to large borrowers in the US fell by 47 percent
during the peak period of the financial crisis (fourth quarter of 2008 relative to previous
quarter). In constraining the supply of credit and therefore raising the cost of external
financing, the financial crisis might have real effects on the economy. Consistent with
this conjecture, Gamba and Triantis (2008) developed a theoretical model to analyse the
effect of financial flexibility on firm value. They demonstrate that the value of financial
flexibility depends, among others things, on the costs of external financing.
A small number of papers analyzes the real economic effects of the 2007-2008
financial crisis empirically. Campello et al. (2010) survey 1,050 CFOs in 39 countries in
the USA, Europe, and Asia to directly assess whether their corporate investment plans
differ conditional on the financial constraints of the firms. Interestingly, they show that
86 percent of financially constrained firms postponed or cancelled their planned
investments. Campello et al. (2010) also show that firms sold more assets during the
financial crisis in order to fund their ongoing operations. In the same vein, but using
archival data, Duchin et al. (2010) document a significant decline in corporate investment
of US firms following the onset of the crisis. More importantly, the decline in corporate
investment is significantly greater for firms that are financially constrained in terms of
low cash reserves and/or high net short-term debt. Duchin et al. (2010) further examine
stock return performance of firms following the onset of the crisis as a function of their
financial flexibility (cash reserves). Using a portfolio approach, they provide evidence
suggesting that cash-rich firms outperform cash-poor firms. Consistent results are also
provided by Tong and Wei (2008) as the authors find that the stock price declines
following the crisis are positively (negatively) associated with firms’ financial
constraints (financial flexibility). Simutin (2010) documents that corporate excess cash
holdings and future stock returns are positively related. However, he finds that it is
“somewhat surprising” that firms with very high levels of cash underperform in down
markets. He argues that such underperformance could be consistent with the idea that
firms build up cash reserves in anticipation of investment opportunities. In down
markets, the value of such growth options is likely to fall, resulting in lower stock returns
for firms with high excess cash. Regarding the firms with very high excess cash
balances, he concludes that “I find no relationship between excess cash and future
profitability, hinting at a possibility of overinvestment by high excess cash firms”.

III. Methodology
3.1 Measuring financial flexibility
To analyse the value of financial flexibility, we sort firms into deciles based on various
proxies for financial flexibility: cash, cash and cash equivalents[6], short-term debt,
total debt, and net debt. The use of cash balances as a proxy for financial slack is Financial
motivated by the studies of Opler et al. (1999) and Duchin et al. (2010). All our results flexibility
are similar when adding up cash and cash equivalents as a measure of financial
flexibility and in the empirical section we only report the results for the aggregated
variable. Total debt is the sum of debt in current liabilities (short-term debt) and
long-term debt with maturities beyond one year. Even though one can argue that only
long-term debt is relevant for investment decisions, we include short-term debt as a 83
firm may finance longer-term projects by a sequence of short-term liabilities. There is a
large literature going back to Fazzari et al. (1988) that studies the impact of financial
constraints on investments in order to answer the question whether constrained firms
are forced to forgo profitable investment opportunities. If firms borrowing at their debt
capacity limit are constrained and underinvest we would expect that financial
constraints affect the firm’s performance negatively. Net debt is defined as total debt
minus cash and cash equivalents. Net debt was put forward by Strebulaev and Yang
(2006) to better reflect whether a firm is seriously financially constrained or whether
high cash balances compensate for high debt-to-asset ratios (Acharya et al., 2007).
Furthermore, Faulkender and Wang (2006) point out that cash reserves and financial
constraints are related. They find that the marginal value of holding cash is greater for
financially constrained firms.
We measure the proxies for financial flexibility of each firm as an average over the
five years prior to the crisis, from September 2002 to August 2007. Using these
characteristics, firms are sorted into ten portfolios. Portfolio 1 contains firms with the
lowest value for the respective characteristic and portfolio 10 the ones with the highest
values. Balance sheet information is taken from Compustat. We exclude financial firms
and firms operating in regulated industries, such as utilities (more specifically, we exclude
SIC codes 4840-4949, 6000-6495, 6700-6799, and $7200). Following Iliev and Welch (2010),
we make a few important adjustments for book value of equity. Book value of equity is
negative for some firm-years. If in addition to equity, debt is also zero, we set book equity
for this firm-year to missing. Otherwise we set the book value of equity to be the maximum
of 0, 1 percent of the firm’s debt, 0.1 percent of the firm’s assets, or the reported book value.
Moreover, we winsorize the ratios cash/assets, cash equivalents/assets, debt in current
liabilities/assets, and long-term debt/assets at the values 0 and 1, and net debt/assets at 21
and 1.
In a second step, we evaluate the performance of each decile portfolio over the crisis
period from September 2007 to March 2010. Any precise dating of the beginning of the
crisis is debatable. In this study, we use September 2007 as the beginning of the financial
crisis when Northern Rock received an emergency loan from the Bank of England
(September 13) and soon after Citigroup suffered major bank write-downs from
subprime mortgage losses (October 16). This choice is also in line with previous studies
(Duchin et al., 2010).

3.2 Estimating the performance

We use monthly stock returns over the evaluation period from September 2007 to March
2010. The return data is taken from the CRSP database which includes all publicly
traded stocks on NYSE, Amex, and Nasdaq. We then calculate monthly excess returns
by subtracting the one-month Treasury rate from the raw return. Using raw returns or
simple excess returns can be misleading as firms with different cash and debt levels
IJCOMA might operate in industries with different risks. Moreover, stock returns of firms with
23,2 different leverage ratios are not directly comparable. We therefore adjust realized stock
returns using the CAPM and the Fama and French (1992, 1993) three-factor model. For
the industry specific analysis, we also compute the stock returns in excess of the average
industry return (at the two-digit SIC industry classification level).
Next, we compute each month the median return for the decile portfolios that rank
84 firms by financial flexibility as described in the previous section. We compute median
decile returns over the full sample period from September 2002 to March 2010. Median
returns are preferred over mean returns to mitigate the impact of a few outliers, which
are typically a major concern in the top and bottom deciles. This procedure results in ten
time series of monthly median decile returns based on all firms for which we can match
return data from CRSP with the balance sheet data from Compustat. Using these decile
portfolio returns over the pre-crisis period, we estimate the market beta coefficient for
the CAPM model and the three factor loadings for the Fama-French three-factor
model[7]. We use these coefficient estimates from the pre-crisis period to compute excess
returns over the evaluation period from September 2007 to March 2010. Alternatively,
we considered re-estimating the coefficients during the crisis. However, due to the sharp
market downturn, the estimated market beta coefficients appear to be inflated.

IV. Results
4.1 Descriptive statistics
Table I shows descriptive statistics for the proxies for financial flexibility that we use to
form decile portfolios: cash, cash and cash equivalents, short-term debt, total debt, and
net debt. As noted above, total debt is computed by adding short-term and long-term
debt, and net debt is the difference of total debt minus cash and cash equivalents.
All financial flexibility proxies are scaled by book value of total asset. The top rows in
Table I contain summary statistics for all 4,434 firms in our sample (as of 2007). The
average cash balances (including cash equivalents) of 22.65 percent are similar to
the average total debt levels of 25.14 percent. Short-term debt is much less used and
the 25th percentile is zero. The distributions of financial flexibility measures by industry
reveal large differences. In particular, cash balances and net debt ratios vary
considerably. Firms in the high-tech business equipment sector (computers, software,
and electronic equipment) and health sector (medical equipment and drugs) are
characterized by high levels of cash and very large negative values for a substantial
fraction of firms, as can be seen from the column for the 25th percentile. Net debt has
consistently the highest standard deviation of all financial flexibility proxies.
In Table II we present the median value for each decile portfolio calculated over the
five-year period from September 2002 to August 2007.Unsurprisingly, these statistics
show that the ratios of cash, cash and cash equivalents as well as debt to book value of asset
are heavily concentrated around zero, as can be seen from the low median values of the first
three deciles. For example, the median values of portfolio 1 are 0.48 percent, 0.59 percent,
and zero for cash, cash and cash equivalents, debt (short-term and total), respectively.
This result is fairly common in the literature (Strebulaev and Yang, 2006; Duchin et al.,
2010). Furthermore, we observe large differences between low and high deciles portfolios.
The net debt ratio is more normally distributed but still concentrated around zero. These
results suggest that, on average, the firms in our sample, which represent a large set of
exchange listed firm in the USA, are parsimonious in their use of leverage.
Industry Variable Mean SD 25th percentile Median 75th percentile n %

Total Cash 16.22 20.32 2.63 8.00 21.20 4,434 100.0

Cash and cash equivalents 22.65 25.81 3.37 11.69 33.38
Short-term debt 7.80 18.67 0.00 0.95 5.90
Total debt 25.14 26.90 1.32 18.54 37.15
Net debt 3.21 43.81 223.72 6.28 29.79
Consumer non-durables: food, tobacco, textiles, Cash 9.41 15.56 1.39 4.32 9.36 297 6.7
apparel, leather, toys Cash and cash equivalents 11.48 16.95 1.47 4.99 13.88
Short-term debt 6.95 14.13 0.07 1.92 6.98
Total debt 27.80 23.37 8.28 24.18 40.84
Net debt 16.36 33.36 0.50 17.93 35.45
Consumer durables: cars, TV’s, furniture, household Cash 11.48 16.04 2.82 5.86 11.79 158 3.6
appliances Cash and cash equivalents 13.59 17.33 3.76 8.08 14.63
Short-term debt 10.80 21.17 0.22 2.51 11.67
Total debt 26.58 25.38 5.44 21.17 38.99
Net debt 14.00 32.27 22.67 12.87 30.36
Manufacturing: machinery, trucks, planes, Cash 11.44 15.90 2.13 5.60 14.25 787 17.7
chemicals, off furniture, paper, commercial printing Cash and cash equivalents 14.35 18.29 2.52 6.86 19.69
Short-term debt 8.55 19.43 0.12 1.62 6.60
Total debt 26.89 25.73 7.35 21.64 37.01
Net debt 13.01 36.64 25.32 12.75 31.40
Energy: oil, gas, and coal extraction and products Cash 9.52 16.11 0.94 3.12 10.61 352 7.9
Cash and cash equivalents 11.99 19.38 1.02 4.10 14.72
Short-term debt 7.22 20.33 0.00 0.23 2.88
Total debt 27.90 24.72 8.61 22.87 39.33
Net debt 16.64 36.00 1.32 17.89 34.12
High-tech business equipment: computers, software, Cash 21.10 18.28 7.61 15.97 29.63 736 16.6
and electronic equipment Cash and cash equivalents 30.85 22.90 11.83 26.02 46.10
Short-term debt 7.57 19.54 0.00 0.26 5.21
Total debt 17.30 25.67 0.00 5.79 25.22
Net debt 212.84 41.39 241.24 216.78 9.68
(continued)
Financial

financial flexibility
flexibility

sample firms (as of 2007)

measures (in %, scaled by
book assets) for all
Summary statistics for
85

Table I.
 86
23,2

Table I.
IJCOMA

Industry Variable Mean SD 25th percentile Median 75th percentile n %

Telecommunication: telephone and television Cash 8.91 10.94 1.81 4.94 11.87 158 3.6
transmission Cash and cash equivalents 11.66 13.50 2.64 6.53 14.52
Short-term debt 6.81 15.71 0.24 2.11 6.61
Total debt 40.24 26.40 20.19 35.56 58.66
Net debt 29.10 33.37 10.31 25.86 49.90
Shops: wholesale, retail, and some services Cash 9.35 14.05 1.73 4.53 11.52 561 12.7
(laundries, repair shops) Cash and cash equivalents 12.34 16.82 1.94 5.68 16.76
Short-term debt 7.40 15.46 0.04 1.06 6.45
Total debt 26.10 24.89 4.41 21.61 38.53
Net debt 14.33 34.47 25.91 15.45 34.63
Health: medical equipment and drugs Cash 32.00 26.58 9.41 24.58 48.50 747 16.8
Cash and cash equivalents 48.49 32.08 17.60 48.57 78.11
Short-term debt 7.92 20.76 0.00 0.32 4.88
Total debt 20.75 30.02 0.00 5.66 28.38
Net debt 225.83 53.06 270.16 232.84 3.66
Other: mines, construction, building materials, Cash 13.91 19.15 2.06 6.65 17.10 638 14.4
transportation Cash and cash equivalents 18.11 21.60 3.33 10.17 24.28
Short-term debt 7.56 17.59 0.00 1.48 6.20
Total debt 29.40 27.51 2.00 25.61 46.18
Net debt 11.47 40.69 210.84 11.96 37.60
4.2 Performance of decile portfolios Financial
In order to test whether financially flexible firms performed better during the recent flexibility
financial crisis than financially constrained firms, we form decile portfolios of firms
using the four measures that are central to this study and compare their returns. The
risk-adjusted performance of these portfolios over the period September 2007-March
2010 is presented in Table III.
While the rankings based on cash positions do not reveal a clear return pattern for 87
decile portfolios 1-6, firms with very high ratios of cash-to-assets exceeding 30 percent
incurred heavy losses (see Panel A of Table III). For decile 10, excess returns over the
risk-free rate average 2 2.45 percent per month during the crisis period. When adjusting
for exposure to market risk by computing the excess return using CAPM, the
performance improves to 2 1.58 percent. Firms with very high cash balances, however,
do not simply exhibit higher market beta coefficients. In fact, the beta of decile 10 is 1.04,
which essentially reflects the average risk of the market. Figure 1 shows that also the
exposure to the three risk factors of the Fama-French model cannot explain the poor
returns of deciles 8-10. This provides evidence that the firm characteristics size and
book-to-market ratio are not driving the underperformance, even though deciles 1 and 10
tend to include smaller firms[8].
The negative returns for portfolios with high ratios of short-term debt and total debt,
i.e. lower financial flexibility, are consistent with our hypothesis that financial flexibility
should be most valuable during a crisis (see Panels B and C of Table III). Figure 2 shows a
sharp underperformance for firms with very high ratios of short-term debt divided by
book assets while sorting on total debt (Figure 3) produces a negative relationship
between debt levels and performance for deciles 6-10. For firms with low levels of debt in
deciles 1-5 the return pattern is essentially flat. The results are robust to our three
different measures of excess return.
When sorting firms into deciles based on net debt-to-asset ratios, returns decrease
from decile portfolio 5 to decile portfolio 10 (Figure 4). Again, this provides support for
the hypothesis that the returns of firms with low levels of financial flexibility suffered
most during the financial crisis. However, firms with very low debt, in fact largely
negative net debt, did not fare well during the crisis either. This pattern is essentially
also reflected in the performance of the decile portfolios sorted by cash and cash
equivalents-to-assets (see Panel A). Firms with very high levels of cash earned poor
returns, risk-adjusted or not (see Panel A, decile portfolios 9 and 10).

Decile Cash Cash and equivalents Short-term debt Total debt Net debt

1 0.48 0.59 0.00 0.00 267.10

2 1.76 2.08 0.05 0.84 236.12
3 3.15 3.82 0.38 5.75 217.72 Table II.
4 5.06 6.39 1.12 12.03 25.15 Average financial
5 7.46 9.59 2.08 18.56 4.55 flexibility measures
6 10.46 14.25 3.33 24.43 13.96 (in %, scaled by book
7 14.80 21.04 5.32 31.69 22.86 value of assets) for decile
8 21.35 30.36 9.05 40.46 32.71 portfolios over
9 30.85 46.27 17.52 54.01 46.66 the period September
10 52.86 73.56 49.94 87.33 80.53 2002 to August 2007
IJCOMA
Excess return Excess return
23,2 Decile Median ratio Raw return Excess return CAPM Fama-French

Panel A: deciles sorted by cash and cash equivalents/book value of assets (Figure 1)
1 0.59 2 0.91 2 1.01 20.66 2 0.82
2 2.08 2 0.83 2 0.93 20.57 2 0.82
88 3 3.82 2 0.93 2 1.03 20.64 2 0.88
4 6.39 2 0.70 2 0.79 20.39 2 0.61
5 9.59 2 0.73 2 0.83 20.44 2 0.67
6 14.25 2 0.76 2 0.86 20.42 2 0.75
7 21.04 2 1.06 2 1.16 20.65 2 1.06
8 30.36 2 1.32 2 1.42 20.76 2 1.27
9 46.27 2 1.36 2 1.47 20.73 2 1.28
10 73.56 2 2.34 2 2.45 21.58 2 2.22
Panel B: deciles sorted by short-term debt/book value of assets (Figure 2)
1 0.00 2 1.10 2 1.20 20.65 2 1.13
2 0.05 2 0.63 2 0.73 20.22 2 0.66
3 0.38 2 0.82 2 0.92 20.46 2 0.89
4 1.12 2 0.90 2 1.00 20.53 2 0.89
5 2.08 2 0.85 2 0.95 20.45 2 0.78
6 3.33 2 1.22 2 1.32 20.89 2 1.15
7 5.32 2 0.93 2 1.03 20.57 2 0.79
8 9.05 2 1.18 2 1.28 20.84 2 1.04
9 17.52 2 1.69 2 1.79 21.34 2 1.63
10 49.94 2 3.09 2 3.19 22.53 2 3.11
Panel C: deciles sorted by total debt/book value of assets (Figure 3)
1 0.00 2 1.18 2 1.28 20.73 2 1.21
2 0.84 2 1.13 2 1.23 20.59 2 1.12
3 5.75 2 1.15 2 1.25 20.77 2 1.17
4 12.03 2 0.95 2 1.05 20.63 2 0.98
5 18.56 2 0.84 2 0.94 20.50 2 0.82
6 24.43 2 0.74 2 0.84 20.40 2 0.67
7 31.69 2 1.09 2 1.19 20.73 2 0.96
8 40.46 2 1.00 2 1.10 20.67 2 0.86
9 54.01 2 1.58 2 1.69 21.14 2 1.41
10 87.33 2 1.89 2 1.99 21.34 2 1.86
Panel D: deciles sorted by net debt/book value of assets (Figure 4)
1 2 67.10 2 2.06 2 2.16 21.32 2 1.93
Table III. 2 2 36.12 2 1.34 2 1.44 20.77 2 1.30
Median values of 3 2 17.72 2 1.04 2 1.14 20.61 2 1.04
financial flexibility 4 2 5.15 2 1.02 2 1.12 20.63 2 1.03
proxies (in %) and 5 4.55 2 0.48 2 0.58 20.20 2 0.51
performance (mean 6 13.96 2 0.85 2 0.95 20.57 2 0.85
returns in % per month) 7 22.86 2 0.74 2 0.84 20.42 2 0.62
of decile portfolios during 8 32.71 2 1.19 2 1.30 20.86 2 1.06
the period September 9 46.66 2 1.12 2 1.22 20.77 2 0.95
2007-March 2010 10 80.53 2 1.33 2 1.43 20.93 2 1.38

What could explain the poor performance of such firms? To answer this question we
need to take a closer look at the arguments of Opler et al. (1999) why firms hold cash.
One motive for holding large cash balances is that firms which operate in a risky
environment, and hence exhibit volatile cash flows, will have a preference to hold more
cash (precautionary savings motive). Thus, it might be the case that in a worldwide
 0.00 Financial
–0.50
flexibility
–1.00
% per month

–1.50
89
–2.00

–2.50

–3.00
1 2 3 4 5 6 7 8 9 10
Figure 1.
Cash and cash equivalents/Book assets deciles Performance of decile
Gross return Excess return portfolios sorted on cash
and cash equivalents
CAPM alpha Fama-French alpha

0.00

–0.50

–1.00
% per month

–1.50

–2.00

–2.50

–3.00

–3.50
1 2 3 4 5 6 7 8 9 10 Figure 2.
Short-term debt/Book assets deciles Performance of decile
Gross return Excess return portfolios sorted on
short-term debt
CAPM alpha Fama-French alpha

event such as the recent financial crisis, firms with risky cash flows perform poorly
despite their financial reserves. Therefore, our results appear to be consistent with
Opler et al. (1999), who use the industry average over the past 20 years as a measure of
cash flow volatility.

4.3 Results for specific industries

It is well known and widely documented that the capital structure of firms differs from
industry to industry. For example, mature manufacturing firms or wholesale firms with
substantial tangible assets have much higher debt-to-asset ratios than firms in risky
industries or growth firms. Therefore, the value of financial flexibility and the motives to
hold high cash balances and low levels of debt need to be analyzed separately by industry.
Among the nine industries to choose from based on the Fama-French industry
classification shown in Table I, we singled out the high-tech business equipment
IJCOMA 0.00
23,2
–0.50

% per month
–1.00

90 –1.50

–2.00

–2.50
1 2 3 4 5 6 7 8 9 10
Figure 3.
Performance of decile Total debt/Book assets deciles
portfolios sorted Gross return Excess return
on total debt
CAPM alpha Fama-French alpha

0.00

–0.50
% per month

–1.00

–1.50

–2.00

–2.50
Figure 4. 1 2 3 4 5 6 7 8 9 10
Performance of decile Net debt/Book assets deciles
portfolios sorted Gross return Excess return
on net ebt
CAPM alpha Fama-French alpha

(computers, software, and electronic equipment) along with the healthcare (medical
equipment and drugs) sector. These two industries are characterized by the highest
average cash holdings coupled with the lowest average net debt levels. Hence, they are
well suited to explore the arguments of Opler et al. (1999) and Simutin (2010): did firms
operating in risky industries benefit from holding precautionary cash reserves during
the financial crisis or did their returns suffer due to vanishing profitable investment
opportunities? The specific results for portfolios formed in these industries are tabulated
in Panels A-C of Table IV.
The results in Panel A reveal that firms with high levels of cash in the healthcare
sector tend to perform worse than firms with lower levels of cash. The
underperformance is particularly strong for deciles 9 and 10 and holds across all
risk-adjusted performance measures. For the decile portfolios of the high-tech sector we
cannot discern a particular pattern. The results in Panel B of Table IV, where debt levels
 Industry excess Excess return Excess return
Industry Decile Median ratio Raw return return CAPM Fama-French

Panel A: deciles sorted by cash and cash equivalents/book value of assets

High tech 1 1.97 2 0.97 0.11 20.67 20.97
2 5.96 2 1.83 20.57 21.36 21.92
3 9.24 2 0.88 0.18 20.34 20.94
4 12.38 2 1.32 20.13 20.55 21.14
5 15.28 2 0.82 0.37 20.23 20.83
6 19.25 2 1.28 20.09 20.49 21.07
7 24.06 2 1.16 0.09 20.52 21.08
8 29.31 2 0.88 0.53 0.18 20.40
9 37.08 2 1.81 20.38 21.02 21.73
10 53.44 2 1.25 0.12 20.31 20.98
Healthcare 1 3.57 0.18 1.22 0.30 20.10
2 9.91 2 0.28 1.03 20.09 20.25
3 17.38 2 0.26 0.81 0.06 20.18
4 25.75 2 0.49 0.88 20.08 20.37
5 35.62 2 2.22 20.84 21.78 22.24
6 49.00 2 0.80 0.41 20.29 20.77
7 57.95 2 2.18 20.71 21.51 22.08
8 70.65 2 2.03 20.44 21.24 21.80
9 82.10 2 2.34 20.81 21.48 22.06
10 92.71 2 2.92 21.22 22.02 22.74
Panel B: deciles sorted by total debt/book value of assets
High tech 1 0.00 2 1.20 0.11 20.58 21.19
2 0.10 2 0.88 0.51 0.03 20.60
3 0.94 2 0.88 0.24 20.23 20.76
4 3.36 2 1.24 0.05 20.45 21.08
5 7.79 2 1.04 0.03 20.46 21.06
6 14.40 2 1.41 20.18 20.79 21.36
7 20.61 2 1.42 0.00 20.69 21.25
8 28.31 2 1.08 0.02 20.51 20.95
9 43.30 2 1.98 20.81 21.17 21.71
10 90.77 2 2.35 21.41 21.32 22.25
(continued)
Financial

financial flexibility

period September
flexibility

portfolios during the

returns in % per month)
performance (mean
proxies (in %) and

2007-March 2010
Median values of

of industry decile
91

Table IV.
 92
23,2

Table IV.
IJCOMA

Industry excess Excess return Excess return

Industry Decile Median ratio Raw return return CAPM Fama-French

Healthcare 1 0.00 2 2.13 20.61 21.49 22.15

2 0.11 2 0.99 0.06 20.57 20.97
3 1.54 2 2.15 20.69 21.43 21.97
4 4.72 2 1.21 0.05 20.87 21.29
5 8.41 2 1.66 20.23 21.25 21.60
6 13.23 2 0.70 0.60 20.27 20.62
7 20.65 2 0.57 0.67 20.27 20.49
8 30.72 2 1.15 0.09 20.76 21.02
9 47.90 2 1.00 0.49 20.16 20.86
10 85.15 2 1.95 20.35 20.88 21.52
Panel C: deciles sorted by net debt/book value of assets
High tech 1 269.05 2 1.32 0.11 20.57 21.32
2 250.87 2 0.98 0.56 20.19 20.82
3 237.77 2 1.05 20.12 20.25 20.82
4 227.70 2 1.43 0.03 20.57 21.17
5 218.02 2 0.63 0.33 20.03 20.65
6 28.50 2 1.08 20.05 20.46 21.21
7 0.62 2 1.42 20.13 20.83 21.36
8 12.03 2 1.83 20.54 21.29 21.74
9 29.44 2 0.87 0.14 20.54 20.85
10 82.71 2 3.59 22.17 22.23 23.07
Healthcare 1 290.62 2 2.91 21.32 22.08 22.81
2 273.42 2 1.96 20.41 21.19 21.73
3 258.26 2 1.73 20.39 21.04 21.62
4 243.69 2 1.44 20.20 21.03 21.48
5 228.62 2 1.68 20.41 21.13 21.70
6 215.93 2 1.36 0.08 20.88 21.14
7 25.08 0.12 1.35 0.56 0.26
8 5.91 2 0.55 0.69 20.31 20.49
9 24.81 2 0.56 0.54 20.22 20.61
10 68.86 2 1.83 20.45 21.31 21.68
are used as a proxy for financial flexibility, are consistent with the results in Table III. Financial
As we move towards portfolios with higher debt levels, returns tend to increase and flexibility
then decrease. For high-tech firms, the tendency towards a decrease in returns as
debt levels increase appears to be more consistent. The value of financial flexibility in
these two industries is mainly due to the flexibility offered by low levels of debt,
especially case of high tech firms. High levels of cash appear to be detrimental to raw or
risk-adjusted returns in the healthcare industry. This is consistent with the findings of 93
Simutin (2010) that during the crisis projected growth options did not materialize and
firms with large cash reserves could not reap the benefits of their financial flexibility.
The resulting effects can best be summarized by looking at the results of net debt in
Panel C. In both industries firms with very low net debt levels experienced a poor
performance, however, even stronger is the underperformance of firms with very high
levels of net debt. This latter result provides evidence for the value of financial flexibility
in difficult market conditions.
There are a number of limitations to our analysis. Most importantly, the
underperformance of firms with limited financial flexibility might be understated in
our study due to a survivorship bias. Using the rankings over the pre-crisis, more firms
with low levels of cash and high levels of debt disappear from the sample during the
crisis. While for firms with the lowest cash and cash equivalent ratios (decile 1) 350 firms
drop from the sample due to bankruptcy or merger/acquisition, the number of
firms decreases by less than half (158 firms) in case of decile 10. By construction, our
results only reflect the performance of the surviving firms during the financial crisis.

V. Conclusion
The objective of this study is to test whether financial flexibility has value. Using the
current financial crisis as a test case, we investigate whether firms that built up financial
flexibility over the years preceding the crisis yield superior performance during the
financial crisis.
Our results show that firms with high levels of debt earned low returns during the
financial crisis. This indicates that firms with low levels of financial flexibility
experienced difficulty to finance their ongoing needs or upcoming profitable projects as
they were no longer able to receive external financing. On the other hand, we also see that
firms with very high cash balances did not fare very well either. How can the
underperformance of these firms be explained? Some recent studies (Simutin, 2010;
Jagannathan et al., 2011) show that cash holdings proxy for future expected growth
opportunities. Firms that expect to come across many profitable investments in the near
future, in the form of promising new internal projects or acquisitions, are likely to have a
desire for financial flexibility. Otherwise, if the firm does not project to invest in
upcoming profitable projects, investors would prefer the firm to pay out excess cash
balances as the additional flexibility would have no value, or even negative value
(Jensen’s free cash flow hypothesis). Consequently, when these expected future
profitable opportunities do not materialize during a crisis, the performance of the stock
of these firms suffers. At the same time, we show that financial flexibility does have
value. This can explain why, for the overall results, we find a concave shape in the
performances of decile portfolios when we rank firms by net debt.
Finally, our analysis shows that, in industries with potential high growth
opportunities such as high-tech, medical equipment and drug firms, the desire to keep
IJCOMA financial flexibility in order to finance expected future growth opportunities appears
23,2 to be important. We conclude that we need to differ between two sources of value:
financial flexibility has value when external financing becomes costly during extreme
market events, and firms maintain high cash balances and low debt levels to seize
profitable growth opportunities. Our empirical findings show that during the crisis
precautionary savings were valuable and resulted in a better performance, while high
94 cash balanced built up in anticipation of investment opportunities did, on average, not
pay off during the crisis and resulted in poor stock returns.

Notes
1. Data from EDGAR online.
2. In addition, Fama and French (2002) find that the tendency of firms to stick to a target
debt-equity mix is surprisingly weak. A long-term target debt-equity mix is one of the
implications of the static tradeoff theory.
3. Among others, Frank and Goyal (2003) and Fama and French (2005) document frequent and
important equity issues and conclude that this is striking evidence against the pecking order
theory.
4. Additionally, firms can retain financial flexibility by building hidden reserves. Assets, such
as plant and property, are recorded in the balance sheet at their initial cost and then
depreciated over time. For mature firms that acquired some of their tangible assets long time
ago, these book values may no longer reflect the underlying market value.
5. According to the free cash flow hypothesis of Jensen (1986), the accumulated financial
flexibility in the form of cash could also result in overinvestment in unprofitable projects.
6. Cash equivalents are assets that are readily convertible into cash, typically Treasury bills,
commercial paper or other marketable securities with maturities up to three months. The last
feature is what distinguishes cash equivalents from short-term investments which mature
within one year, and long-term investments with maturities beyond one year.
7. Returns on the three factor mimicking portfolios (market, small-large firms, and
value-growth firms) are downloaded from Kenneth French’s web site.
8. The factor loadings on the size factor of the Fama-French three-factor model are 0.91 and
1.04 for deciles 1 and 10, respectively, compared to an average of 0.62 for deciles 2-8.

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About the authors

96 Iwan Meier, PhD, is an Associate Professor of Finance at HEC Montreal. He currently teaches
finance courses at the undergraduate studies and at the MBA. His research interests focus on
corporate finance.
Yves Bozec, PhD, is an Associate Professor of Accounting at HEC Montreal www.hec.ca/sco/
profs.html. He teaches financial and managerial accounting at the undergraduate studies. His
main research interests focus on corporate governance, and particularly on the link between
corporate ownership structure and performance. Yves Bozec is the corresponding author and can
be contacted at: yves.bozec@hec.ca
Claude Laurin is Professor of Accounting at HEC Montreal. He teaches management
accounting and he is one of three co-authors of a textbook covering all aspects of management
accounting. His research interests and publications lie primarily in the areas of corporate
governance, performance measurement and privatization.

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