Implications of Insufficient and Excess Cash for Future Performance.

Although a large body of accounting research has investigated the value relevance of operating cash flow, there has been scant research investigating whether a buildup of cash flow, or lack thereof, affects firm value. This is despite that fact that financial statement analysis requires a determination of the cash holdings necessary for liquidity purposes and then decision making on how a firm will allocate the remaining cash between investment opportunities, dividend distribution, or the repurchase of shares. This paper investigates whether future performance suffers when a firm deviates from an estimated “target” cash level. If a firm’s estimated target cash level provides a reasonable proxy for a firm’s optimal cash level, then future performance should be decreasing in both positive and negative deviations. We begin by modifying prior cash models to produce an improved estimate of target cash. We then show that one-year-ahead return on net operating assets and one-year-ahead abnormal stock returns are decreasing in the level of deviation from the estimated target, with returns results being most pronounced for firms with insufficient cash. Finally, we show that the anomalous results of Penman, Richardson, and Tuna 2007, which suggest that investors misprice firm leverage, pertain only to firms with insufficient cash, where interest payments may be most constraining. Our findings demonstrate the importance of cash level for a firm’s future performance, aid in the understanding of the relationship between cash levels and leverage, and provide support for the static trade-off model of corporate financing. [ABSTRACT FROM AUTHOR]