Corporate Cash Savings: Precaution Versus Liquidity

Abstract

Cash holdings as a proportion of total assets of North American corporations have roughly doubled between 1971 and 2006. Prior research attributes the large cash increase to a rise in firms’ cash flow volatility. We investigate two mechanisms by which increased volatility can lead to higher cash holdings. The first is the precautionary motive inducing firms to be prudent about their future prospects. The second mechanism is the liquidity motive requiring firms to meet their current liquidity needs. We find that the liquidity motive best explains how the increased volatility nearly doubled cash holdings.

Keywords: dynamic capital structure, cash holdings, precautionary savings, corporate liquidity

JEL Classification: G31, G32, G35, E21, E22