Determinants of Corporate Cash Holdings:

A Case Study of Pakistan

Talat Afza and Sh. Muhammad Adnan∗

ABSTRACT
Maintaining appropriate level of liquidity within the organization is fundamental towards
the smooth operations of firms. Managers have a tendency to hold large proportion of
firm assets in the form of cash and cash equivalents in order to reinvest on other physical
assets, payments to stockholders and to keep cash inside the firm (Almeida et al, 2002).
The level of cash a firm maintains is characterized by its policies regarding capital
structure, working capital requirements, cash flow management, dividend payments,
investments and asset management. In the literature, the impact of these factors is
normally analyzed under the framework of Tradeoff Model, Myers’ Pecking Order
Theory and Jensen’s Free Cash Flow Theory, e.g. Opler et al. (1999), Ozkan and Ozkan
(2002), and Ferreira and Vilela (2004). The current study focuses on determining the
level of corporate cash holdings of non-financial Pakistani firms, across different firm
sizes and different industries. Furthermore, dataset for the period 1998-2005 for the firm
size, growth opportunities, cash flow, net working capital, leverage, cash flow uncertainty
and dividend payments has been statistically analyzed to determine the impact of these
factors on corporate cash holdings. The findings of the study are in conformity with the
earlier research and reflect that firm size, cash flow, cash flow uncertainty, net working
capital, and leverage significantly affect the cash holdings of non-financial firms in
Pakistan.

Keywords: Cash Holdings, Liquidity, Agency Problem

JEL Code: G11, G31, G32

Introduction

Cash and cash equivalents are considered as some of the most important component of

current assets and are the lifeline of corporate financial Management. The Managers hold

a substantial portion of their assets in the form of cash and liquid securities for

reinvestment in physical assets, distribution to investors and to keep cash inside the firm

(Almeida et al, 2002). The corporate cash holdings patterns are usually explained under

three theories, namely, tradeoff model, pecking order theory and free cash flow theory.

∗
The authors are professor and lecturer respectively, at Department of Management Sciences, COMSATS
Institute of Information Technology, Lahore, Pakistan. E-mail: talatafza@ciitlahore.edu.pk,
sadnan@ciitlahore.edu.pk
According to the tradeoff model, firms set their optimal level of cash holdings by
weighting the marginal costs and marginal benefits of holding cash. The main benefits
associated with cash holdings include reduction in the likelihood of financial distress,
pursuance of the optimal investment policy even when financial constraints are met, and
its contribution to minimize the costs of raising external funds or liquidating existing
assets (Ferreira and Vilela, 2004). While marginal cost of holding cash is associated with
the opportunity cost of the capital due to the low return on liquid assets.

As per the pecking order theory (Myers 1984), firms finance investments firstly with
retained earnings, then with safe debt and risky debt, and finally with equity. When
current operational cash flows are sufficient enough to finance new investments, firms
repay debt and accumulate cash. When retained earnings are not enough to finance
current investments, firms use the accumulated cash holdings and, if needed, issue debt.

Free cash flow theory by Jensen (1986) explains that Managers have an incentive to
hoard cash to increase the amount of assets under their control and to gain discretionary
power over the firm investment decision. With the cash holding, they do not need to raise
external funds and could undertake investments that have a negative impact on
shareholders wealth.

Maintaining appropriate level of liquidity within the organization is fundamental for

smooth operations of the firm and the level of cash a firm maintains is characterized by
its policies regarding capital structure, working capital requirements, cash flow
management, dividend payments, investment and asset management (Opler et al. 1999).
A number of researchers have investigated the determinants of cash held by firms of
developed countries, but the same issue has not been evaluated for corporate firms in
developing countries.

The present study focuses on determining the level of corporate cash holdings of
Pakistani firms, across different firm size and different industries. Moreover, the behavior
of different factors affecting a firm’s cash holding is also studied. The findings of the

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study suggest that Pakistani firms hold a considerable amount of assets in the form of
cash and equivalents and this phenomenon is prevalent across all firm size. Moreover,
cash was found to be significantly affected by investment opportunity set, cash flow
magnitude, liquid assets substitutes, debt level and cash flow uncertainty.

Literature Review

Existing literature has mainly focused on evaluating the cash balances across different
firm sizes and industries of developed countries in order to establish a relationship
between asset management practices and firm performance. In an earlier study, Nadiri
(1969) empirically tested the determinants of Real cash balances in the US manufacturing
sector. Taking quarterly data on manufacturing sector from 1948 to 1964, he estimated a
model relating the desired level of real cash balances to the expected level of its
operations and movements in the opportunity cost money, the user cost of capital
services, the price of labor services, and the general price level. The estimated results
revealed that the demand for real cash balances is determined by output (wealth), the
interest rate, the expected rate of change in the general price level, and factor prices.

Later, Campbell and Brendsel (1977) empirically examined the impact of compensating
balance requirements on the cash holdings of US firms for the period 1953-1963. By
employing the Miller and Orr’s OLS regression of the target cash balances over the cash
holdings by the firms, they find that compensating balance requirements are not binding.
These results are further verified by applying Cochran-Orcutt technique.

Opler et al. (1999) examined the determinants and implications of holding cash and cash
equivalents by 1048 publicly traded US firms in the period 1971-1994. Their results show
that cash holdings are negatively related to size, net working capital, leverage, dividend
payment, and govt. regulation while they are positively related to the cash flow-to-assets
ratio, the capital expenditures-to-assets ratio, industry volatility, and the R&D-to-sales
ratio. They concluded that firms with better growth opportunities and riskier cash flows
had higher levels of cash, while large firms having better access to capital markets hold

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less cash. Similar results were reported by Faulkender (2002) for a sample of small US
firms and Ozkan and Ozkan (2002) for a sample of UK firms.

Considering the agency costs that aris due to excessive cash levels, Harford (1999)
empirically studied the notion that excessive cash leads the managers to make value
decreasing investment decisions. He estimated a sample of all acquisition attempts by US
firms during the period 1977-1993. The results support the hypothesis that acquisition by
cash rich firms are value decreasing. Moreover, they are more likely to make diverse
acquisitions, and their targets firms are less attractive to other bidders. The similar
phenomenon is observed in bidder firms in a merger depicted by sharp decline in
operating performance.

Pinkowitz and Williamson (2001) examined the effect of bank power on cash holding
patterns of industrial firms for a sample of Japanese firms for the period 1974-1995,
German firms for the period 1984-1994 and US firms for 1971-1994. The cross country
analysis show that Japanese firms tend to hold more cash than their American or German
counterparts do. While cash holding pattern was similar across German and US firms, the
OLS regression analysis reveal that Japanese cash balances are significantly influenced
by the monopoly power of the banks. This is consistent with the fact that high cash
holdings mean higher rents extracted by the banks during the periods when they enjoy
certain power in the corporate lending system.

Dittmar et al. (2003) tested the significance of corporate governance in determining the
corporate cash holdings. They collected the data of more than 11,000 firms (including 30
from Pakistan) from 45 countries for the year 1998 and employed a shareholders’ rights
index developed by La Porta et al. (1998). The results reveal that the firms in countries
with low shareholder protection hold upto twice as much cash as firms in countries with
high shareholder protection. In case of poor shareholder protection, the factors
determining corporate cash holding, such as investment opportunities and asymmetric
information become less important. Furthermore, they find that with the easier access to
funds, firms hold larger cash which supports the agency theory.

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Ferreira and Vilela (2004) investigated the determinants of corporate cash holdings using
a sample of 400 firms in 12 EMU countries including Germany, Austria, France, Greece,
Italy, Netherlands, Portugal, Spain, Belgium, Ireland, Finland and Luxemburg for the
period 1987-2000. The results show that cash holdings are positively influenced by
investment opportunity set and firm cash flows. While, assets’ liquidity, leverage, firm
size and bank debt negatively affect the cash holdings. Low levels of cash are held by
firms in countries with superior investor protection and concentrated ownership.

Nguyen (2005) investigated the hypothesis that cash balances have a precautionary
motive and serve to mitigate the volatility of operating earnings, which they used as a
proxy for risk. Their results show that cash holdings are positively associated with firm
level risk, but negatively related to industry risk. Consistent with past researches, cash
holdings were found to be decreasing with the firm’s size and debt ratio, and increasing
with its profitability, growth prospects, and dividend payout ratio.

Guney et al (2006) examined the impact of leverage on cash balances of firms, which
they argued may be non-monotonic. A negative (substitution effect) relation between
leverage and cash holdings exists to the extent that leverage of firms acts as a proxy for
their ability to issue debt. However, with the increase in leverage, firms may accumulate
larger cash reserves so that the risk of financial distress and costly bankruptcy can be
minimized. Therefore, at high levels of leverage, a positive (precautionary effect)
relationship between cash holdings and leverage exists. Their results suggest a significant
non-linear relationship between cash holding and leverage. Furthermore, Country specific
characteristics such as degree of creditor protection, shareholder protection and
ownership concentration can influence the strength of the impact of leverage on cash
holdings.

Drobetz and Grüninger (2006) investigated the determinants of Swiss non-financial

firms’ cash holdings over the 1995 to 2004 period. Their results show that the median
Swiss firm holds almost twice as much cash and cash equivalents as the median UK or
US firm. Moreover, they found a negative relationship between asset tangibility and cash

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holdings and a non-linear relationship between leverage and cash holdings. Dividend
payments were positively related to cash reserves. However, they could not prove a
significantly positive relationship between growth opportunities and cash holdings.

Recently, Hofmann (2006) examined the determinants of corporate cash holdings of non-
financial firms in New Zealand. His findings suggest that the main determinants of
corporate cash holdings in New Zealand are firms’ growth opportunities, the variability
of its cash flows, leverage, dividend payments, and the availability of liquid asset
substitutes. While growth opportunities and the variability of cash flows are positively
related to cash holdings, large dividend payments and liquid asset substitutes indicate
lower cash holdings.

The empirical researches reveal that that the firm specific factors affecting the corporate
cash holdings have differing relationship across different countries and firm sizes.
Moreover, the behavior of these variables has been changing over time. The literature
does not provide considerable research on determinants of corporate cash holdings in
developing countries. The current research tries to fill this gap by analyzing the behavior
of firm specific factors with respect to corporate cash holdings in Pakistan.

Data and Methodology

A sample of 205 public limited companies listed at Karachi Stock Exchange (KSE) is
selected over a period of eight years (1998-2005). Financial firms have been excluded
from the sample for the obvious reason that the factors determining their cash
requirements are altogether different from the non-financial firms. The exogenous
variables used to evaluate the cash holdings of the firms in this research include growth
and investment opportunities, real size of the firm, cash flow, liquidity requirements,
Leverage, cash flow uncertainty, and dividend payments. While hypothesizing the
relationship between cash levels and these variables, the expected behavior of each of
them would be examined under the three theoretical models.

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Opler et al. (1999) model is used to study the determinants of cash holdings. According
to this model, cash holdings is a function of growth opportunities, riskiness of cash flow,
access to the capital markets, and the cost of raising funds through asset sales and
dividend cuts. For this research, the variables such as capital expenditures, R&D
expenditures and Regulatory Dummy have been excluded because of non-availability of
data in Pakistan. For firm i in year t, the cash model is given by the following equation:

CASHi,t = α + β1MTBi,t + β2SIZEi,t + β3CFi,t + β4NWCi,t + β5LEVERAGEi,t +

β6INDSIGi,t + β7DIVDUMi,t + εt (1)

Where, Cash holdings (CASH) are represented by cash ratio

CASH = Cash and cash equivalents _

Book value of assets – cash and equivalents

Market-to-book ratio (MTB) is taken as a proxy for the firm’s investment opportunity set.

MTB = Book value of assets – book value of equity + market value of equity
Book value of assets
Natural logarithm of total assets is taken as a proxy for the real size (SIZE) of firms. Cash
flow magnitude (CF) is measured by Cash flow to net assets ratio

CF = After Tax profit + Depreciation _

Total assets – cash and equivalents

Net working capital-to-assets ratio (NWC) is taken as a proxy for liquid asset substitutes
as these assets can be seen as substitutes for cash holdings.

NWC = Net current assets – Cash and cash equivalents

Total assets – cash and equivalents

Leverage (LVRG) is measured as

LVRG = Total Debt _

Total assets – cash and equivalents

Standard deviation of industry cash flow (INDSIG) is used to measure Cash flow
uncertainty, which is computed using the procedure suggested in Opler et al. (1999). A

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dummy variable is constructed to estimate the effects of dividend payments (DIV) that is
set to one if the firm paid dividends in each year and set to zero if it did not.

Results

Descriptive statistics show the mean, percentiles and standard deviation of the variables
and provide a general overview of the characteristics of the data.
Table 1
Descriptive Statistics
25th 75th Standard
Variable N Mean percentile median percentile Deviation
CASH 205 0.135177 0.0239 0.060075 0.151294 0.253184
MTB 205 1.134351 0.846945 0.958039 1.185571 0.954183
SIZE 205 7.072591 6.193176 6.918783 7.808879 1.344384
CF 205 0.113959 0.0541 0.095961 0.151389 0.105642
NWC 205 -0.00841 -0.1015 -0.02614 0.09336 0.159201
LVRG 205 0.150856 0.053798 0.139405 0.205654 0.125305
INDSIG 205 0.086268 0.064824 0.077023 0.095361 0.032776
DIVDUM 205 0.665244 0.375000 0.750000 1.000000 0.335861

The mean cash ratio over the sample is 13.5% which is considerably large for non-
financial firms. These statistics are very close to the US firms’ mean cash ratio of 17% as
reported by Opler et al (1999) and the European firms’ mean cash ratio of 14.8% as
reported by Ferreira and Vilela (2004). The overall mean market-to-book ratio is 1.13.
This figure represents a low level of investment opportunities for Pakistani firms in
comparison to European and American firms who have market-to-book ratio of 1.71 and
1.53 respectively. Mean value of leverage is 15% which again suggests that Pakistani
firms have a tendency to use lesser amount of debt to finance their assets as compared to
their counterparts in developed countries (26.1% in US firms and 24.8 in EMU
countries).

A pooled time series regressio0n has been estimated to evaluate the factors influencing
corporate cash holding. The estimated results are reported in table 2 below.

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 Table 2
Estimates of Exogenous variables on Corporate Cash Holdings
Unstandardized Standardized
Coefficients Coefficients
Model B St. Error Beta t Significance
Constant -0.237 0.074 -3.212 0.002
MTB -0.040 0.012 -0.150 -3.296 0.001
SIZE 0.031 0.009 0.167 3.336 0.001
CF 1.769 0.130 0.738 13.558 0.000
NWC -0.299 0.082 -0.188 -3.662 0.000
LVRG -0.321 0.107 -0.159 -3.002 0.003
INDSIG 1.254 0.363 0.162 3.455 0.001
DIVDUM -0.103 0.045 -0.137 -2.306 0.022

We find that market-to-book ratio coefficient is significant at 1% level, consistent with

free cash flow theory that states that managers with poor investment opportunities (low
market-to-book ratio) hold more cash to ensure availability of funds for investment in
growth projects which may earn a negative NPV. This result suggests the agency problem
is prevalent in Pakistani firms, where managers try to avoid raising external funds for
keeping the investment information of the company to themselves.

Firm size, cash flow and industry sigma are significant at 1% level in the cross sectional
regression analysis. The positive coefficient on cash flow-to-assets ratio supports the
pecking order theory which suggests that firms finance investments first with the retained
earnings and then go for debt. This result is, however, in contradiction to tradeoff model
as reported by the earlier researches for firms in developed countries, i.e. Opler et al.
(1999) Ozkan and Ozkan (2002) and Ferreira and Vilela (2004). The reason for this
incongruity may be high cost of external debt in Pakistan.

The sign on industry sigma is positive and significant which is in conformity with the
expectations and empirical research. It suggests that firms with greater cash flow
volatility hold more cash in order to provide a safe cushion for smooth operations.
The results support the notion that firms with higher leverage hold less cash, which is
consistent with pecking order and free cash flow theories. As per the pecking order
theory, when firms’ investments are in excess of retained earnings, high levels of debt

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and little cash holdings occur simultaneously. This negative relationship is also supported
by free cash flow theory but the main reason is because high leverage firms are subject to
monitoring by capital markets preventing superior managerial control.

The negative sign on net working capital is consistent with the notion that firms with
higher liquid assets substitutes hold less cash which is consistent with the expected
relationship between the two variables.

Conclusion

The level of corporate cash holdings and its determinants has been the topic of a number
of researches in the past. However, almost all of them investigated the issue for the firms
in developed nations and few analyzed the cash holdings patterns of the firms in
developing countries. The present study tries to fill this gap by investigating the
determinants of cash holdings for 205 non-financial Pakistani firms for the period 1998-
2005.

The descriptive statistics show that firms on average hold 13.1% cash for investment and
financing purposes. Consistent with the practice in developed nations, this is generally a
high level of cash holdings which may suggest the existence of managers’ wish to keep
the liquid assets under their control. Such phenomenon indicates the agency problems
these firms may be facing.

The study models the cash-to-asset ratio as a function of firm specific factors including
firm size, growth opportunities, cash flow, liquid assets substitutes, leverage, cash flow
uncertainty and dividend payments The behavior of the these variables was analyzed
under the framework of three theories of corporate cash holding, i.e. tradeoff model,
pecking order theory and free cash flow theory.

The regression results indicate that all the variables in the model are significant in
defining the cash levels of Pakistani firms. Consistent with the empirical research, Firm

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size, cash flow and cash flow uncertainty are positively associated with the cash levels of
the firm These results indicate that larger firms hold more cash to follow the pecking
order pattern of financing the investments and to avoid illiquidity in case of cash flow
volatility.

Investment opportunities, liquid assets substitutes, leverage and dividend payments are
found be negatively influencing the corporate cash holdings. This phenomenon, on one
hand, indicates the existence of agency problem in Pakistani firms, while on the other
hand, supports the pecking order theory of cash holding.

Keeping in view the dearth of researches on cash holdings and agency problems in
developing countries, the present study can provide an insight into the issue with respect
to Pakistani firms. The future researches should explore the impact of corporate cash
holdings on firms’ profitability and performance.

References

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Liquidity: A Theory and Some Evidence” Working Paper, University of Illinois and
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Campbell, T. and Brendsel, L. (1977) “The impact of compensating Balance

Requirements on the Cash Balances of Manufacturing Corporations: An Empirical
Study” The Journal of Finance Vol. 32 pp. 31-40

Dittmar, A., Mahrt-Smith, J. and Servaes, H. (2003) “International Corporate Governance

and Corporate Cash Holdings”, Journal of Financial and Quantitative Analysis, Vol. 28,
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Drobetz, W. and Grüninger M. (2006) “Corporate Cash Holdings: Evidence from a

Different Institutional Setting” presented at 9th SGFconference

Faulkender, M. (2002) “Cash Holdings among Small Business”, Working Paper (Kellogg
School of Management, Northwestern University)

Ferreira, Miguel A. and Vilela, Antonio S. (2004) “Why Do Firms Hold Cash? Evidence
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Guney, Y., Ozkan, A. and Ozkan, N. (2006) “International Evidence on the Non-linear
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Hofmann, C (2006) “Why New Zealand Companies hold cash: An empirical Analysis”
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