Master Thesis Liquidity management before and during the recent financial crisis

Master Thesis Liquidity management before and during the recent financial crisis An investigation of the trade-off between internal funds (cash, cash flow and working capital) and external funds (lines of credit) during normal and financially distressed times and an analysis of the usage of credit lines covenants Student: Sara Westling Student number: 6166636 Supervisor: Dr. Erasmo Giambona July 2013

Abstract Liquidity management is essential to any firm at any time. However, efficient corporate liquidity management is particularly important during a financial crisis when there is uncertainty and scarcity of funds on the financial markets. The recent financial crisis has resulted in an opportunity to analyze how the shortage of external funds generally affects firms liquidity management. The aim of this research paper is to investigate the interaction between lines of credit, cash holdings, cash flow and working capital before and during the recent financial crisis. Two years are chosen for this research, namely, 2005 and 2008, which respectively represent a non-crisis and crisis period of time. The research is based on a unique hand-gathered dataset, which is collected by manually assessing annual reports and additional financial information is obtained from the Compustat database. When investigating firms liquidity management certain key firm characteristics as well as potential industry effects are also taken into account. Furthermore, attention is given to the usage of credit lines covenants in order to investigate whether credit line providers imposed more restrictions on their borrowers due to the financial crisis. Thus, it will be interesting to see whether the uncertainty and scarcity of funds on the financial markets during 2008, generally affected corporate liquidity management. The overall results of this study suggest that the lines of credit are negatively related with cash holdings, suggesting that credit lines and cash savings are substitutes. The findings also indicate that cash flow is essential to a firm s ability to obtain and sustain a line of credit. Thus, lines of credit and cash flow are found to be positively related however the positive effect of cash flow on lines of credit diminishes as cash holdings increases. Additionally, it seems that firms with a high level of internal funds tend to draw fewer funds from their revolving credit facilities. The relationships between lines of credit, drawdowns and the internal liquidity variables vary to some extent among different industries. Working capital is considered a substitute to cash savings and it seems to generally have a positive relation with credit lines. Furthermore, the financial crisis typically resulted in an increase in the usage of the credit lines covenants. 2

Table of content 1 Introduction... 4 2 Literature review... 7 2.1 Liquidity during the recent financial crisis... 8 2.2 Relationship between lines of credit, cash holdings and cash flow... 8 2.3 Firm characteristics effect on liquidity management... 9 2.4 Working capital; additional source of liquidity... 10 2.5 Covenants... 11 3 Data collection... 12 4 Methodology... 13 4.1 Descriptive statistics... 13 4.2 Firm characteristics... 14 4.3 Relationship between liquidity variables... 15 4.4 Subsample analysis... 17 4.5 Statistical covenant measures... 17 5 Results & Discussion... 18 5.1 Liquidity management at a glance... 18 5.2 Mean comparison analysis... 20 5.2.1 Lines of credit and drawdowns by firm characteristics... 20 5.2.2 Cash holdings and cash flow by firm characteristics... 21 5.3 Correlation analysis... 23 5.4 Regression analysis... 24 5.4.1 Regression analysis - Lines of credit, cash flow and cash holdings... 24 5.4.2 Regression analysis Credit line size, cash flow and cash holdings... 26 5.4.3 Regression analysis - Drawdowns, cash flow and cash holding... 27 5.4.4 Regression analysis Working capital as additional source of liquidity... 28 5.4.5 Regression analysis Subsample... 30 5.5 Covenants analysis... 31 6 Conclusion... 33 Bibliography... 36 Appendix... 39 3

1 Introduction Liquidity management is the practice of ensuring that a company has enough cash or cash equivalents to meet its expected and unexpected financial obligations. Additionally, it should have sufficient resources of funds to be able to make long-term investments. The liquidity sources at a firm s disposal consist of for example its cash savings, which is the cheapest and most accessible source of credit. However, a firm can also have access to external funds, such as a line of credit. A revolving credit facility (line of credit) is an agreement from a financial institution to lend funds to a borrower until a certain limit is reached and the lender can impose certain restrictions on the borrower, which are known as covenants. A line of credit can be used to fill the liquidity shortage of a firm. A shortage of credit can be very costly for a company if it means forgoing profitable investment opportunities. Efficient liquidity management is therefore essential to any firm at any time. However, liquidity management is even more crucial during a financial crisis, when there is uncertainty and scarcity of funds on the financial market. The recent financial crisis has resulted in an interesting period of time to study, and the aim of this research paper is to analyze how a credit crunch affects corporate liquidity management. Namely, the trade-off between internal funds (cash holdings, cash flow and working capital) and lines of credit is investigated for 2005, a year of regular economic environment, and 2008, a year of financial turmoil. The research questions of this paper are therefore as follow: How did the relationship between internal and external sources of financing change during the recent financial crisis? & How did the usage of line of credit covenants evolve during this period of time? A line of credit is an important part of corporate liquidity management. However, extensive empirical research of this subject is lacking. A reason for this could be that financial information on lines of credit is generally not accessible from databases. This thesis will therefore contribute to existing literature by empirically investigating the interaction between lines of credit and internal funds, during normal and distressed times, using a unique handgathered dataset. The sample set consists of public non-financial companies from the US. The firms data concerning lines of credit and their related covenants is manually collected by assessing annual reports via the Securities and Exchange Commission website (www.sec.gov) and additional financial information is obtained through Wharton Research Data Services and the database Compustat. This research builds on the investigation made by Sufi (2009), who for first time collected extensive data on lines of credit. He concluded, among other things, that lines of credit are an important part of corporate liquidity management and that firms with 4

a high level of cash flow consider credit lines as a viable substitute of liquidity. Campello, Giambona, Graham and Harvey (2011) have also contributed to this field of research. Namely, based on a survey, where international CEOs were asked about their liquidity management during the financial turmoil, they concluded that a positive relation between lines of credit and cash flow exists for companies with a low level of cash holdings, and they also found that financially unconstrained firms tend to hold a lower ratio of credit lines to total assets. Additionally, Campello et al. (2011) concluded that firms with lower levels of cash savings and cash flow tended to draw a higher proportion of funds from the available lines of credit. However, this investigation will differ from previous research since a new event window will be studied; a different sample set of firms will be used; liquidity management among various industries will be investigated; attention to an additional liquidity source (working capital) will be given and its effect on liquidity management will be studied; and whether the financial crisis affected the usage of lines of credit covenants will be researched for the first time. The results of this study will be relevant for firms and financial institutions. For example, it is important for firms to know how financial instability on the market can affect the external supplies of credit and what kind of restrictions financial institutions usually impose on a borrower, both during normal and financially distressed times. Additionally, the findings of this study can be relevant for economic policy-making as well as for academic purposes. In this research paper certain firm characteristics will be defined with the aim of investigating whether liquidity management differs among various types of firms. Namely, the sample will be divided controlling for size, investment grade, bank dependency and profitability. A mean comparison analysis will be performed for different liquidity sources while controlling for firm characteristics. The findings will give insight on how firm characteristics affected the liquidity management during the non-crisis and the crisis period. Previous research has, for example, concluded that access to lines of credit is greater among large, profitable, non-bank dependent companies with an investment grade, which are firms that can be considered as financially unconstrained (Campello, Graham and Harvey, 2010). The overall results of the mean difference test are in line with the findings of Campello et al. (2010), that the majority of firms with an available line of credit are unconstrained firms. Additionally, the outcome of the analysis reveal that unconstrained firms tend to hold a lower ratio of cash savings to total assets, which is consistent with the results of Almeida, Campello, and Weisbach (2004). 5

A correlation matrix and several ordinary least squares (OLS) regressions will be made with aim of analyzing the relationship between the different liquidity variables (lines of credit, drawdowns, cash holdings, cash flow and working capital) that are included in this study. The results indicate that cash flow has a positive effect on the access to a line of credit. However, this positive effect mitigates as cash holdings becomes larger and an increase in the cash flow ratio will not generally result in an increase in the size of the credit line. A revolving credit facility is concluded to be a valid substitute of cash savings, which is in line with the findings of Sufi (2009). Drawdowns from credit lines are highest among firms with a low level of internal liquidity, which also supports the findings of previous research. Working capital is throughout this paper defined as accounts receivable plus inventory minus accounts payable, while controlling for total assets. Working capital is negatively related with cash holdings during the financial crisis. Thus, working capital and cash savings can, during this period of time, be considered substitutes of liquid assets. Lines of credit and working capital seem to generally have a positive relationship, which indicates that providers of credit lines often require their borrowers to keep a certain level of accounts receivable and inventory as collateral. Small and bank dependent firms tend to have a higher level of working capital during the financial crisis compared to large and non-bank dependent companies. This outcome follows the line of existing research which argues that constrained firms, on average, have a higher demand for liquid assets, such as working capital (Almeida and Campello, 2010). This thesis paper will, additionally, contribute to previous research by analyzing whether the relationship between internal and external funds is diverse among different industries, before and during the recent credit crunch. This research s dataset consists to 99% of manufacturing firms from different divisions. Thus, this study will, by performing OLS regressions including an industry dummy variable, provide information on whether corporate liquidity management differs among various manufacturing segments. The findings of the industry analysis show that liquidity management differs, to some extent, among various manufacturing segments. For example, firms which produce chemical and allied products tend to have a slightly lower access to lines of credit during the crisis period compared to other manufacturing firms. 6

The usage of lines of credit covenants inside and outside the credit crisis will also be examined to further increase the contribution of this study. A mean difference test will be performed and the results indicate that the usage of credit line restrictions generally increased during the financial turmoil. However, the only increase that can be considered significant at a 10% test level, when comparing the non-crisis and the crisis period, is the usage of the M&A clause. Hence, providers of revolving credit facilities tended to significantly more often restrict their borrowers from engaging in consolidations or from making acquisitions during the financial crisis. An introduction to this paper s topic, liquidity management before and during the recent financial crisis, has now been provided. The remaining part of this thesis is organized as follows; the next section (2) will present the literature review where the findings of previous studies concerning the interaction between internal and external funds as well as firm characteristics effect on liquidity management and the usage of covenants will be discussed. In the subsequent sections (3) and (4), the data collection and the methodology of this study will be described, respectively. Section (5) will follow, where the empirical results will be presented and discussed. In the final section (6), a conclusion of the research will be provided to summarize the findings concerning the financial crisis s effect on corporate liquidity management. 2 Literature review In order to investigate the liquidity management, specifically the interaction between internal funds and lines of credit during normal and distressed financial times, it is important to know when lines of credit are typically provided and under which conditions they are generally drawn. In this section, the credit supply during the recent financial crisis will therefore be discussed. Further, the results of previous conducted studies concerning the relationship between lines of credit, cash holdings and cash flow will be analyzed. Firm characteristics also have an effect on the liquidity sources at their disposal. Therefore, the findings of existing research concerning firm characteristics and their liquidity management effects will also be discussed. Furthermore, a discussion of the effects of working capital on liquidity management will be provided. Finally, the usage of covenants will be discussed. 7

2.1 Liquidity during the recent financial crisis During the recent financial crisis, liquidity dried up which resulted in a decrease of credit supplies from banks (Cornett, McNutt, Strahan and Tehranian, 2011). Ivashina and Scharfstein (2009) noted that when the financial crisis hit the market, firms had difficulties to roll over their short term debt due to a run of short term bank creditors. However, the aggregate balance sheet of the US s banking sector actually showed an increase by $100 billion of loans from September to mid-october in the year of 2008 (Chari, Christiano, and Kehoe, 2008). This was due to an increase in drawdowns of already committed lines of credit (Ivashina et al., 2009). A paper by Gao and Yun (2009) discussed the effect of the financial crisis on the usage of commercial papers and credit lines for nonfinancial firms. They found similar results. Namely, they concluded that the aggregate use of commercial papers declined during the crisis, especially among firms with a high default risk and that these high-risk firms tended to substitute commercial paper borrowings with lines of credit. Thus, during financially distressed times, when liquidity is scarce, previous studies have found that firms tend to take advantage of their already established lines of credit and thus make more drawdowns. This paper will research whether similar result can be found when using this unique dataset. 2.2 Relationship between lines of credit, cash holdings and cash flow Lines of credit are an important part of corporate liquidity management. Nevertheless, there has been a limited amount of empirical research within the field of credit lines. However, in 2009, Sufi made an extensive contribution with his paper Bank Lines of Credit in Corporate Finance: An Empirical Analysis, which analyzed the management of liquidity. In particular, the choice between cash and lines of credit was investigated. He concluded that from 1996 to 2003, nearly 85% of the firms in his sample had obtained a line of credit. Thus, credit lines are undoubtedly an important factor of liquidity management. Sufi (2009) also concluded that lines of credit are a viable substitute of liquidity at least for firms with a high level of cash flow, whereas firms with a low level of cash flow tend to rely more heavily on cash. Sufi (2009) also pointed out that the usage of cash flow based covenants is very common and that this is an important factor of the positive relationship between cash flow and lines of credit. Thus, in order to meet the line of credit requirements, firms often have to maintain a high level of cash flow. This indicates that firms with a higher level of cash flow can more easily obtain and sustain credit lines. Additionally, this could explain why companies may or may 8

not choose to use lines of credit. Furthermore, Sufi (2009) found evidence of a negative relationship between cash holdings and lines of credit, which suggests that a substitution effect between cash holdings and lines of credit exists. However, a paper by Huang (2010), discussing the usage of credit lines during the recent financial crisis, concluded that lines of credits are not perfect substitute for cash holdings, at least not for smaller and more risky firms. This paper will research whether similar results can be found for this study. Campello et al. (2011) studied how different types of liquidity sources, namely how cash, cash flow and lines of credit, interacted during the recent financial crises. Their research, which was based on surveying international CEOs on their liquidity management during the financial turmoil, showed that when firms are facing a credit crunch they substitute between internal funding and lines of credit. However, firms without access to lines of credit tend to choose between saving and investing when liquidity is scarce. Similar to Sufi (2009), Campello et al. (2011) found that credit lines and cash flows are positively related. However, they only found this relationship for firms with low cash holdings. Additionally, they researched how the liquidity management affected firms decisions regarding capital investment, technology spending, and employment during the credit crisis. They concluded that lines of credit seem to have eased the effects on corporate investments during the financial crises. Moreover, Campello et al. (2011) showed that companies with a higher level of cash savings and cash flow tended to draw a smaller proportion of funds from the available lines of credits. Ivashina et al. (2009) and Campello et al. (2010) argued in their respective papers that the usage of credit lines increased during the financial crisis. 2.3 Firm characteristics effect on liquidity management Literature concerning the effects of firm characteristics on liquidity management found that financially constrained firms have a tendency of saving more cash than unconstrained firms (Almeid et al., 2004). The paper of Opler, Pilkowitz, Stulz, and Williamson (1999) revealed similar results, that unprofitable companies and firms without access to financial markets tend to have a higher level of cash holdings. Another study, argued that constrained firms hold more cash as a value-increasing response to expensive external funding (Denis and Sibilkov, 2010). Moreover, Campello et al. (2010) found evidence that small, unprofitable, and private firms without an investment grade, thus constrained firms, have a larger proportion of credit 9

lines to total assets. This study will also investigate how firm characteristics affect liquidity management. 2.4 Working capital; additional source of liquidity Most literature has focused on internal funds in terms of cash holdings and cash flow. However, working capital can also be seen as a part of internal liquidity. Fazzari and Petersen (1993) argued that working capital is a source of liquidity that is often neglected and that can, in addition to cash savings, be used to smooth fixed investments when firms face financial constraints. Working capital is defined as current assets, such as accounts receivable and inventory, minus current liabilities, as for example accounts payable (Fazzari et al., 1993). Enqvist et al. (2012) found, when researching a sample of Finnish listed firms from 1990 to 2008, that managing working capital is more important during financially distressed times than during better general economic circumstances. Additionally, Enqvist et al. (2012) argued that working capital is a key factor of firms liquidity and should therefore be included in firms financial planning. However, a survey performed by PwC (2009) on European companies showed that very little attention has been given to increase the efficiency of working capital between 2005 and 2008. A firm s characteristics might also affect whether a firm will choose to alter their level of working capital. Since, financially constrained firms tend to react differently to uncertainty on the market than unconstrained firms (Korajczyk and Levy, 2003). Constrained firms do not only worry about the financing of current expenses and investments, but also about future ones (Almeida et al., 2010). Therefore, constrained firms tend to have a higher demand for liquid assets than unconstrained firm and especially during a crisis when external liquidity is limited and very costly to obtain. As stated by Bates, Kahle, and Stulz (2009), net working capital consists of assets that are substitutes for cash holdings. Hence, both cash savings and working capital can be considered liquid assets. When a financial crisis hits the market, it is expected that firms will choose to increase their working capital in order to decrease their needs for external financing and to secure funds for future investment opportunities (Almeida et al., 2010). It is also expected that companies with a current line of credit agreement are less affected by a decrease of credit supplies during a financial crisis since they can draw funds from their credit lines. Therefore, it is likely that these firms will 10

not feel that a buffer of liquid assets is necessary to secure financing for future capital expenditures. Thus, lines of credit are from this aspect, expected to be negatively related to the level of working capital. However, it should be pointed out that lines of credit can, at times, be collateralized by accounts receivable and inventory. Additionally, the amount available to be borrowed under the line of credit does sometimes depend on the firm s level of inventory and accounts receivable. This could imply that lines of credit are actually positively related to the level of working capital. Since a firm with a current line of credit might, for example, be restricted to hold a certain level of inventory as collateral. This is in line with the findings of Agarwal, Chomsisengphet, and Driscoll (2004), who investigated private held firms with a line of credit and found that profitability and working capital have a positive effect on the size of the obtained credit line. This research paper will investigate this issue and conclude the relation between working capital, lines of credit and cash savings. 2.5 Covenants A covenant is a certain restriction imposed by a lender on the borrower. Covenants are commonly present in different types of financial contracts, such as private and public debt, and private equity (Chava and Roberts, 2008). Financial institutions usually also provide lines of credit restricted by some contractual covenants. These restrictions are developed in order to mitigate the risk for conflict of interest between the lender and the borrower. Hence, the covenants are intended to decrease the agency problem and consequently protect the lender (Smith and Warner, 1979). Chava et al., (2008) argued that covenants are set tightly and are regularly violated. Violations of covenants can result in increased fees and markups. Additionally, it can restrict a firm s access to credit facilities (Campello et al., 2010 and Sufi, 2009). Demiroglu and James (2010) found that line of credit agreements usually contain more restrictive and tight covenants for riskier and less transparent firms. Line of credit covenants often prohibit firms from taking on additional indebtedness and engaging in asset sales. Additionally, they usually restrict the firms payments of dividends to its shareholders unless certain conditions are met (Lins, Servaes, and Tufano, 2010). Thus, firms that regularly pay dividends might be less likely to consider lines of credit as a substitute for cash holdings. Smith and Warner (1979) argued that it is not surprising that dividend restrictions are often imposed on borrowers. Since, if dividend payments are financed by a reduction in the firm s investment expenditures, it will reduce the expected value of the company s assets and thus increase the likelihood of default. Other common covenants concern restrictions of 11

investments and M&A. These clauses can be expensive when firms must forgo profitable investment opportunities. In times of financial distress it can be expected that financial institutions that provide lines of credit will increase the usage of covenants and tighten these restrictions in an attempt to secure their interest. 3 Data collection A hand-gathered unique dataset is used to investigate how lines of credit affect corporate liquidity management. The dataset contains detailed information of credit lines and their associated covenants for nonfinancial US public firms. The years 2005 and 2008 are investigated. The sample contains data of 2212 US public companies for 2005 and of 1775 US public firms for 2008. The data concerning firms lines of credit, drawdowns and covenants are found by manually assessing annual 10-K or 10-KSB (small business) reports via the Securities and Exchange Commission website (www.sec.gov). Following the methodology lines of Sufi (2009), certain key words, such as, credit lines, credit facility, revolving credit agreement and line(s) of credit, are used to search for the required information to justify whether a firm has a line of credit at the end of the fiscal year and under which conditions this credit lines is agreed upon. Hence, the paragraph surrounding the key word often reveals whether the line of credit is still valid at the end of the fiscal year, the total size of the credit line agreement and what the outstanding amount is. Additionally, the line of credit covenants which the firm needs to be in compliance with are usually stated. Information about the following covenants are collected; total leverage, dividends, investment, asset sale, M&A and share repurchase. If a firm is restricted by a certain line of credit covenant, a 1 is stated for that specific covenant, otherwise a 0 is notated. Moreover, additional financial information concerning cash holdings, cash flow (EBITDA), total assets, credit rating, accounts receivable, inventory and accounts payable is obtained through Wharton Research Data Services and the database Compustat. The dataset contains mostly manufacturing US public firms. Namely, 99% of the companies are classified as manufacturing firms, based on their four-digit Standard Industrial Classification (SIC) code. These companies have a SIC codes ranging from 2000 to 3999 and are therefore classified as manufacturing firms. The SIC codes were further used to identify and divide the sample into 20 different industries within the manufacturing sector. This was done with the purpose of the subsample analysis, which will investigate whether the relationship between internal funds and externals funds differ among different manufacturing 12

industries. Table 12 in the appendix provides additional information and presents the number of observations for each division. Following the lines of Campello et al. (2011), the liquidity variables are defined as below and these definitions are used throughout this paper. Table 1. Variable definitions Variable Line of credit: Cash flow: Cash holdings: Drawdowns: Working capital: Definition Total line of credit commitment to total assets EBITDA to total assets Cash and marketable securities to total assets Outstanding loan to total line of credit commitment Working capital to total assets 4 Methodology In this section the methodology of this study will be discussed. In order to answer the research questions concerning the relationship between internal funds and lines of credit, and the usage of lines of credit covenants, a number of statistical measures will be taken. A summary statistics will first be carried out, to give a glance on the liquidity management before and during the crisis. Then, a mean comparison analysis will be made in order to investigate whether the liquidity management significantly changed from 2005 to 2008 and how firm characteristics affect the management of liquidity. OLS regressions will follow, exploring the relationship between the key variables; cash holdings, cash flow, working capital, lines of credit and drawdowns. Regressions including the industry factor will also be carried out. Finally, a mean difference test will be taken to analyze the usage of covenants and to conclude whether the financial crisis made credit lines lenders impose more restrictions on the borrowers. 4.1 Descriptive statistics In order to get a first insight on when lines of credit are usually provided and drawn, and how credit lines are related to cash holdings, cash flow and working capital, a summary statistics will be carried out for the years 2005 and 2008. Thus, this will provide a picture on how the liquidity management changed when the recent financial crisis hit the market. The descriptive 13

statistics will include the percentage of firm having a line of credit, and the variables; line of credit, drawdowns, cash holdings, cash flow, working capital which follows the definitions described in the previous section. A number of firm characteristics will also be included, which are presented in more detail in the following part. In order to investigating the internal liquidity sources and the firm characteristics, the complete sample will be divided into two subsamples; firms with a current credit line and companies without a line of credit. This will give insight on the relation between the lines of credit and internal funds as well as which types of firms generally have access to lines of credit. The mean, the standard deviation, the 25 th, the 50 th, and the 75 th percentile will be reported for each variable in the summary statistics, as well as the sample size. 4.2 Firm characteristics In order to analyze the liquidity management for different types of firms, the sample will be divided controlling for certain firm characteristics. Namely, the size, the investment grade, the profitability of the firm, and whether the firm is bank dependent, will be taken into account. Campello et al. (2011) followed below qualifications when defining a borrower as regular/unconstrained or as non-regular/constrained. This research paper will follow the same definitions lines. Table 2. Constraint versus unconstraint borrower Constraint borrower Unconstraint borrower Small: Sales $1 billion Large: Sales > $1 billion Bank dependant: No S&P credit rating Non-bank dependent: S&P credit rating Non-investment grade: No credit rating, or credit rating < BBB- Investment grade: Credit rating BBB- Unprofitable : Negative net income Profitable: Positive net income Campello et al. (2011) found, as described in the literature review, that regular firms dominate the sample containing firms with a line of credit. Thus, according to previous research, large, profitable, non-dependent firms with an investment grade tend to more often have access to lines of credit. To test whether this statement also holds for this dataset a comparison of the means will be performed. Namely, with the aim of researching whether the liquidity management diverges among different types of firms and whether the management of funds significantly changed during the financial crisis, a two-tailed mean difference test will be carried out where the variables; lines of credit, drawdowns, cash holding, and cash 14

flow will be reported, conditional on above mentioned firm characteristics. Additionally, the percentage of firms with a line of credit and the percentage of companies with a drawdown, taking the firms characteristics into account, will also be included in the mean comparison analysis. 4.3 Relationship between liquidity variables The literature review showed that previous research has found a positive relationship between cash flow and lines of credit, which indicates that firms with a higher level of cash flow more easily can obtain and sustain credit lines. Existing literature has also found evidence of a negative relationship between cash savings and lines of credits, which suggests that a substitution effect between cash holdings and lines of credit exists. This also implies a negative relation between cash savings and drawdowns. Working capital is expected to have a negative relation with cash holdings since they can be considered substitutes of liquid assets. In order to investigate the correlation between these liquidity variables; credit lines, cash holdings, cash flow, drawdowns and working capital, a correlation analysis will be carried out, for 2005 and 2008. The results will show whether the outcomes of this study are in line with the findings of previous research. To further investigate the relation between the liquidity sources a number of OLS regressions will be performed. Following the lines of Campello et al. (2011), the effect of internal funding (cash and cash flow) on the level of availability of credit lines will first be estimated by an OLS regression while controlling for firm characteristics. To investigate whether the liquidity management differs over normal and financially distressed times, the regressions will be computed separately for 2005 and 2008. Furthermore, the regression will be computed for the whole sample, consisting of firms with and without lines of credit, as well as for the sample containing exclusively companies with a current credit line. The purpose of this is to provide additional insights of the relation between the liquidity sources. Hence, the additional regression based on the line of credit sample, will show the effect of cash flow and cash holdings on the size of the credit line. The regressions are based on following formula. LC i =c+ α 1 Cash flow i + α 2 Cash holdings i + α 3 (Cash flow*cash holdings) i + γx i + ε i 15

Where: Line of credit (LC), Cash flow, and Cash holdings are following the specified definitions. X is the control variable of firm characteristics, thus, controlling for size, bankdependency, grade of investment and profitability. ε is the error term. The aim of the next regression, also in line with the research of Campello et al. (2011), is to determine whether firms with a high level of cash flow and cash savings tend to draw less from their credit lines which is suggested by existing literature. This regression will also be computed for both years of interest with aim of researching whether the financial crisis affected the relation between these variables. DD i = c + α 1 Cash flow i + α 2 Cash holdings i + α 3 (Cash flow*cash holdings) i + γx i + ε i Where: Drawdowns (DD), Line of credit (LC), Cash flow, and Cash holdings are following the specified definitions. X is the control variable of firm characteristics, thus, controlling for size, bank-dependency, grade of investment and profitability. ε is the error term. As described in the literature review, working capital is an additional source of internal liquidity. Working capital is here defined as accounts receivable plus level of inventory minus accounts payable, controlled by total assets. Below regressions will be carried out with the aim of investigating the relationship between lines of credit, working capital and cash. It will be interesting to see whether firm characteristics, cash savings and access to a line of credit affect the level of working capital. The regressions will be carried out for both 2005 and 2008, in order to investigate whether the relationships diverge over the credit crisis. LC i =c+ α 1 Cash flow i + α 2 Cash holdings i + α 3 (Cash flow*cash holdings) i + α 4 Accounts receivable i + α 5 Inventory i + α 6 Accounts payable i + α 7( Current assets*current liabilities) i + γx i + ε i WC i =c + α 1 Cash flow i + α 2 Cash holdings i + α 3 (Cash flow*cash holdings) i + α 4 LC i + γx i + ε i Where: Line of credit (LC), Cash flow, Cash holdings and Working capital (WC) are following the specified definitions. X is the control variable of firm characteristics, thus, controlling for size, bank-dependency, grade of investment and profitability. Current assets 16

consist of accounts receivable and inventory and current liabilities represent accounts payable. ε is the error term. 4.4 Subsample analysis The dataset used for this research paper consists mostly of manufacturing firms and the sample is divided into 20 different manufacturing industries based on their SIC codes. The six out of these 20 divisions with the highest number of observation will be included in this analysis, as shown in table 12. This subsample research will enable a conclusion of whether liquidity management is diverse among different manufacturing industries and whether the financial crisis had a stronger affect on some particular division. Below regression will be carried out for both 2005 and 2008, and a dummy variable is included to control for industry. LC i =c+ α 1 Cash flow i + α 2 Cash holdings i + α 3 (Cash flow*cash holdings) i + βindustry i + γx i + ε i Where: Line of credit (LC), Cash flow, and Cash holdings are following the specified definitions. Industry is the dummy variable for manufacturing division, i.e. Food & Kindred Products, Chemicals & Allied Products, Industrial Machinery & Equipment, Electronic & Other Electric Equipment, Transportation Equipment, and Instruments & Related Products. X is the control variable of firm characteristics, thus, controlling for size, bank-dependency, grade of investment and profitability. ε is the error term. 4.5 Statistical covenant measures One of this paper s research questions is to analyze how the covenants have evolved from 2005 to 2008. As presented in the literature review, the usage of lines of credit covenants can be expected to have increased during the recent financial crisis. This will be researched by computing the percentage of firms with a specific covenant, hence determining the mean of the usage of each covenant for the non-crisis and the crisis period. Thus, only the firms with a current line of credit will be taken into account. The credit line covenants included in this study are, as already mentioned, total leverage, dividends, investments, asset sale, M&A and share repurchase. A two-tailed mean difference analysis will then be performed, in order to determine if the financial crises significantly affected the usage of covenants. Since the dataset used in this study only contains dummy variables equal to 1 when a firm is restricted by a certain line of credit covenant and otherwise the dummy variable is equal to 17

0, it will be impossible to conclude whether the restrictions are set tighter. Thus, this research will only be able to conclude whether more covenants are used during the financial crisis. 5 Results & Discussion In this section the results of the statistical measures, taken in order to answer this study s research questions, are presented and discussed. The tables which report the findings of the statistical measures can be found in the paper s appendix. The results of the summary statistics will first be analyzed, providing a broad picture of the liquidity management inside and outside a financial crisis. Then the outcome of the mean difference test will be analyzed, revealing whether liquidity management significantly differs among different types of borrowers and whether these relationships were affected by the financial crisis. The results of the correlation analysis and the outcome of the OLS-regressions will follow, where the relationship between cash, cash flow, working capital, lines of credit and drawdowns will be discussed. The OLS regressions will also take firm characteristics into account. Additionally, the results of the industry analysis will be evaluated, revealing whether liquidity management differs among different manufacturing divisions. Finally, the findings concerning the usage of covenants will be analyzed in order to conclude whether more restrictions were imposed on borrowers during the credit crisis. 5.1 Liquidity management at a glance The summary statistics presented in table 3 in the appendix show the liquidity management at a glance before and during the financial crisis. Specifically, the table reports the mean, the standard deviation, the 25 th, the 50 th and the 75 th percentile for the key variables included in this research as well as the sample sizes. As can be seen in the table, around 67% of the firms in this sample have a line of credit in 2005, this number increase to 69% in 2008. Thus, these results are consistent with the conclusion of Sufi (2009) that lines of credit are an important part of liquidity management. The variables; line of credit, drawdowns, cash holdings, cash flow and working capital are included in the statistical summary and they follow their specified definitions which are presented in table 1. The descriptive statistics results reveal that in 2005 an average firm tended to have a line of credit representing 18% of its assets. In 2008, this number had increased with 1%. Drawdowns increased from 18% in 2005 to 22% in 2008, which indicates that firms took more advantage of their lines of credit during the 18

financial crisis when liquidity was scarce. In order to investigate whether liquidity management is different among firms with and without a line of credit, the sample was divided into these two groups for the remaining part of the summary statistics. It can be seen that firms with access to a line of credit tend to hold less cash than companies without a line of credit. Specifically, in 2005 it was found that firms with a line of credit have a cash holding ratio of 16% whereas firms without a line of credit have a cash holding ratio of 48%. Thus, companies with no access to a line of credit tend to feel a stronger need to keep more cash on their balance sheet. Similar results were found for 2008. It should also be noted that the ratio of cash savings to total assets slightly decreased from 2005 to 2008. Hence, all types of firms tended to use their cash savings to a larger extent during the crisis. Furthermore, firms with a line of credit tend to have positive cash flow to total asset ratio whereas companies without a credit line on average have a negative cash flow ratio. This holds for both investigated years. This supports the argument of Sufi (2009), that to be able to receive and sustain a line of credit firms are often required to have positive cash flows. The summary statistics concerning working capital shows that for both 2005 and 2008 firms with a line of credit have approximately a 13% higher working capital ratio than firms without a line of credit. This indicates, as previously discussed, that firms with a line of credit are often required to keep a certain level of working capital. However, the working capital ratios are more or less constant for the investigated years, namely, around 25% for firms with a credit line and approximately 12% for companies without a line of credit, for both 2005 and 2008. This suggests that the financial crisis did not make firms alter their level of working capital. Lines of credit are provided to firms who the lender believes will be able to meet the required obligations. Thus, it can be expected that credit lines are generally given to unconstrained borrowers, that is, large, profitable firms with a satisfying S&P rating. In order to investigate this, the summary statistics were also here carried out for the two samples; firms with and without access to a line of credit, while controlling for firm characteristics. The results show that the sample of companies with a line of credit are to a larger extent firms that are financially unconstrained, thus profitable firms with sales over $1 billion and with an investment grade above BBB-. For example, 38% of the firms with a line of credit are considered large firms whereas only 6% of the firms without a credit line have sales over $1 billion. Notable is also that 71% of the firms with a line of credit were profitable in 2005 19

while in 2008 only 60% of these firm had positive net income, which can be a result of the financial distress during this year. 5.2 Mean comparison analysis In this part the results of the mean difference test will be presented and discussed, which will reveal the liquidity management among different types of firms, before and during the crisis. Firstly, the findings concerning credit lines and drawdowns conditional on firm characteristics will be analyzed. Secondly, the results of cash holdings and cash flow with respect to firm characteristics will be reported. 5.2.1 Lines of credit and drawdowns by firm characteristics The results from the two-tailed mean difference test concerning lines of credit and drawdowns while controlling for firm characteristics are reported in table 4, which can be found in the appendix. The firm characteristics follow their pre-specified definitions and the years 2005 and 2008 are included in the comparison. Column 1 shows that approximately 60% of the small firms and around 91% of the large firms have access to a line of credit in 2005. Similar results are found for 2008, column 2. Thus, it can be concluded that for both investigated years, the majority of firms with a line of credit are large firms, i.e. firms with sales above $1 billion. Roughly, the same results are found when considering bank dependency and investment grade. There is a slight, but significant (10% test level) increase from 2005 to 2008 of the percentage of firms with a credit line that are non-bank dependent and that have an investment grade. It can also be noted that profitable firms dominate the sample of firms which have a line of credit, and that the difference between unprofitable and profitable firms ability to receive a line of credit is significant. Thus, these findings are in line with the results of Campello et al. (2011) that access to lines of credit is significantly greater among large, profitable, non-bank dependent companies with an investment grade. Column 3 and 4 show the percentage of firms with a drawdown at the end of the investigated fiscal year conditional on having access to a credit line. Thus, this sample only contains firms with an available line of credit. For the year of normal economic circumstances, 2005, it can be seen that constrained firms tend to more frequently draw funds from their lines of credit than regular borrowers. However, this difference is only significant at 1% test level when comparing small and large firms and when comparing unprofitable and profitable firms, 20

in 2005. For the crisis period, 2008, a significant difference concerning how often firms tend to draw funds from the credit lines can only be found when comparing unprofitable and profitable firms (1% test level). It is interesting to notice that the percentage of firms with an outstanding credit line at the end of the fiscal year increases for all types of companies from 2005 to 2008. However, only five out of these eight increases can be considered significant at a 5% test level. This indicates that, when the financial crisis hit the market, firms generally tended to more often take advantage of their available lines of credit. The average size of lines of credit, among different types of firms for the years 2005 and 2008, are presented in column 5 and 6, respectively. These columns reveal that small, unprofitable, bank dependent firms without an investment grade, thus firms which are more heavily constrained by credits, tend to have higher lines of credit to total asset ratios. The results are, for both years, significant at a 5% significance level when comparing the defined firm characteristics. These findings confirm the conclusion of Campello et al. (2010) that constrained firms have a larger proportion of credit lines to total assets. Moreover, the ratio of credit lines to total assets, tended to generally slightly increase from 2005 to 2008. However, only for small, bank dependent firms without an investment grade can this increase be considered significant at a 5% test level. The results of column 7 and 8 show that constrained firms on average drew considerably more funds from their lines of credit than unconstrained firms did. These results are significant at a 1% test level for all types of borrowers and for both investigated years. For example, in 2005, small firms with a line of credit drew on average down 21% of their available credit supplies while large firms on average drew down 11% of their revolving credit facility. Moreover, the drawdown ratio increased from 2005 to 2008 for all types of firms. The increases of these outstanding credit lines are significant at a 5% level, except when considering unprofitable firms. 5.2.2 Cash holdings and cash flow by firm characteristics Table 5, in the appendix, reports the result of the two-tailed mean comparison analysis for cash holdings and cash flow with respect to firm characteristics for the investigated time periods, 2005 and 2008. Column 1 and 2 report the level of cash holdings while controlling for different types of firms and by taking the entire sample into account, i.e. both firms with 21