Financial Conservatism. Determinants of cash and leverage conservatism Dissertation

Financial Conservatism. Determinants of cash and leverage conservatism in USA firms - Dissertation Example Microsoft, Exxon, Apple are all examples of non-financial firms that have held huge stockpiles of cash1. According to a recent San Francisco Chronicle report, Apple reportedly has a stockpile of $137 Billion, and the company justifies this by saying that it is â€Å"preserving its options†2. In financial literature, a firm which holds more cash reserves or lower leverage than is optimal according to capital structure is known to be financially conservative. To avoid having to depend on costly external sources of debt, having spare debt capacities by maintaining low liabilities to total asset ratios is important. Also for the same reason, retaining adequate cash reserves is also important. From 1980 to 2004, the average cash-to-asset ratio for industrial US firms has increased by 129 percent. During the same time period, net debt for these firms has fallen substantially (Bates et al, 2009). Therefore, on average these firms seem to have adopted more financially conservative pra ctices in both senses by reducing leverage and increasing cash holdings simultaneously. However, much of the reduction in net debt is attributed to higher cash holdings rather than any reduction in liabilities. In general financial conservatism has become a very relevant topic of study in this backdrop. In this context, this paper studies the characteristics of financially conservative firms. The main objective is to see whether financially conservative practices can protect firms from being distressed and what effects the financial crisis had on financially conservative practices. Barring Iona, Leonida and Ozkan (2004), Prior research has focused on analysing conservative behaviour of firms from either the perspective of holding excessively high cash balances or from the perspective of maintaining lower than optimal leverage levels. Iona, Leonida and Ozkan (2004) look at non-financial financially conservative UK firms that adopt both these practices simultaneously. No work prior wo rk has examined the coexistence of both cash conservative and leverage conservative practices for US firms. Using a large sample of industrial US firms over the period of 2002-2011, I enquire into the nature of financial conservatism. Since a firm is financially conservative if it is conservative in terms of holding extra cash reserves as well as maintaining low leverage, I start off by looking at the determinants of cash conservativeness and the determinants of leverage conservativeness. Then I look at what are the important characteristics of firms that contribute to making its financial practices conservative in general. In particular, I ask, what factors influence the probability of a firm being both cash and leverage conservative at the same time. After determining the important factors, I turn to the critical question of how financial conservatism affects the probability of a firm being financially distressed. The major contributions of this paper are twofold: first, extending the literature on conservative firms which adopt both cash and leverage conservatism simultaneously and second, applying the theory of jointly cash and leverage conservative practices to characterize conservative US firms which have not been examined in literature at all. The rest of the paper is structured as follows. Section II presents a review of the relevant literature. This section lays out the