Financial Flexibility, Leverage, and Firm Size1
by
Soku Byoun
Hankamer School of Business
Baylor University
One Bear Place 98004
Waco, TX 76798
Tel: (254) 710–7849
Fax: (710) 710-1092
Email: Soku [email protected]
January 2007
1
We would like to thank the GAMF. We appreciate the support for this project that was provided
by the Hankamer School of Business at Baylor University.
Financial Flexibility, Leverage, and Firm Size
Abstract
We find that small firms have lower leverage ratios, not because of internally generated
funds or additional debt financing (as implied by the pecking order theory) but because of
additional equity financing (consistent with our financial flexibility hypothesis). This finding can be explained by neither of the pecking order theory and the tradeoff theory—the
pecking order may be reversed for small firms that prefer external equity to debt financing
while the tradeoff theory may miss out some important aspects of capital structure decisions. We argue that small firms maintain low leverage by issuing equity and building up
cash holdings for financial flexibility. Debt covenant often carry restrictions on financing
and investment decisions that are especially cumbersome for small, growing firms. Equity
financing allows small firms to raise cash without impeding financial flexibility. Consistent
with this argument, we find small firms build up cash holdings in order to preserve financial
flexibility through external equity. Once we account for financial flexibility, the positive
relationship between firm size and leverage found in previous studies is unclear.
JEL Classification: G32
Keywords: Financial Flexibility; Trade-off theory; Pecking-order theory
I. Introduction
Empirical studies in the capital structure find a positive relationship between firm size
and leverage.1 Suggested explanations in the literature include: large firms tend to have
more leverage perhaps because they are more transparent; have lower asset volatility; more
diversified; naturally sell large enough debt issues so that the fixed costs of public borrowing
are not prohibitive; have lower probability of default and less financial distress costs. On the
other hand, small firms incur higher costs of issuing debt or equity since they are subject to
severe asymmetric information problems and default risk, more likely to be growing firms
with volatile cash flows and hence have less access to external funds than do large firms.
Further, the costs of financial distress are likely to be particularly severe for small firms
because much of their value comes from growth options whose value depreciates rapidly if
the firm experiences financial distress. In addition, small firms have a large fraction of their
assets that are firm specific or intangible, limiting their value as collateral.
Given that small firms grow faster than large firms (Evans (1987)), there are two alternatives for small firms to have lower leverage; by financing their growth either exclusively
through retained earnings or through external equity. Most explanations for the positive
relationship between firm size and leverage assume implicitly or explicitly that external
equity is prohibitively expensive for small firms and hence small firms’ financing should
come exclusively from internal funds.2 There is also evidence that firms prefer internal
financing to external financing.3 According to the pecking order theory (Myers and Majluf (1984)), adverse selection costs of external equity are much greater than those of debt.
1
For example, see Titman and Wessels (1988), Rajan and Zingales (1995), Graham,
Lemmon, and Schallheim (1998), Hovakimain, Opler, and Titman, (2001), Booth et al.
(2001) and Fama and French (2002). However, Faulkender and Petersen (2006) find a weak
or negative relationship between the leverage and firm size.
2
See, for example, Frank and Goyal (2003), Leary and Roberts (2005), Strebulaev (2006),
and Kurshev and Strebulaev (2006) for such arguments.
3
See Hovakimian, Opler, and Titman (2001) and Hovakimian, Hovakimian, and Tehranian (2004).
1
Issuance costs are also much greater for equity than for debt.4 Facing such high adverse
selection/transaction costs, small firms should avoid issuing equity by all means. Hence
the literature has paid little attention to the potential role of external equity in relaxing
financing constraints of small firms in debt financing.
We suggest the desire for “financial flexibility” as an alternative explanation for small
firms’ low leverage and yet their reliance on external equity financing. Recently, the survey
results of Graham and Harvey (2001), Bancel and Mittoo (2004), and Brounen et al. (2004)
show that corporate managers explicitly express that they are mostly concerned about
“financial flexibility” in their capital structure decisions. We first examine the concept of
financial flexibility closely, paying special attention to those features of flexibility brought
to light by recent management and organization literatures. The term is very broad and has
many legitimate uses that need not be forced under a single definition. At the same time
it will be necessary to define the term more clearly so as to avoid the confusion from its
various uses in the finance literature. Thus, we first develop a concept of financial flexibility
and then investigate the relevance of financial flexibility to capital structure decisions.
We define financial flexibility as the degree of capacity and speed at which the firm can
mobilize its financial resources in order to take reactive, preventive and exploitive actions
to maximize the firm value. We are persuaded that all of the uses of flexibility pertinent to
the finance literature are encompassed by its reactive, preventive and exploitive nature.
In view of financial flexibility, change in profit (especially loss) can be important determinant of leverage. Specifically, firms with negative retained earnings (from the accumulation
of losses) are likely to have little financial flexibility and debt capacity but ample needs
for additional cash. Our main hypothesis is that firms with negative retained earnings are
more likely to issue equity to build up cash holdings in order to preserve financial flexibility
and hence have low leverage. The corollary to this hypothesis is that cash holdings will be
negatively associated with leverage. We also examine if small firms’ lower leverage can be
4
Altinkilic and Hansen (2000) find that equity issuing costs are on average 5.38% of the
issue proceeds while debt issuing costs are on average 1.09%. Leary and Roberts (2005)
also report significantly larger equity issuance costs.
2
explained by the consideration of financial flexibility focusing on the relationship between
firm size and leverage.
We find that large firms retain much more earnings than small firms and that low leverage for small firms results from external equity financing rather than internal funds. While
small firms avoid debt financing, they are much more active in tapping into external equity
capital. Firms with negative retained earnings have lower leverage ratios and issue several
times more equity than firms with positive retained earnings. We also find that small firms
have negative retained earnings with more cash holdings than other firms. Thus, our findings are consistent with the argument that small firms build financial flexibility through cash
holdings and equity financing to cope with their “abnormal” periods of earnings shortfalls
(DeAngelo and DeAngelo (2006)).
We further show that firm size has an overall strong and significant positive association
with leverage ratios. However, the positive relationship between firm size and leverage ratios are substantially weakened or reversed for large firms when we divide firms re-estimate
regressions for firms divided into small/large and positive/negative retained earnings. Also,
negative retained earnings dummy variables are associated with significant and positive
coefficient estimates, suggesting lower leverage ratios for firms with negative retained earnings. On the other hand, when we include retained earnings as a continuous variable in
the subgroup regressions, positive retained earnings are significantly and negatively associated with leverage ratios, whereas negative retained earnings show less economically and
statistically significant association with leverage ratios. Thus, our results show that firms
with negative retained earnings build up cash holdings through equity financing, lowering
leverage ratios, whereas firms with more positive retained earnings also have lower leverage
ratios through the accumulation of earnings (as a means of building financial flexibility).
Overall, the relationship between leverage and firm size is not clear.
Our study brings new evidence to bear on an important issue in the capital structure
literature. The literature has wrestled with the problem of sorting out the effects of adverse
section costs of asymmetric information on capital structure.5 On the one hand, the liter5
For example, see Myers and Majluf (1984), Viswanath (1993), Chang and Dasgupta
3
ature finds that larger firms tend to issue more debt relative to equity than smaller firms
and hence appear to provide a better fit for the pecking order theory (Shyam-Sunder and
Myers (1999) and Frank and Goyal (2002)). On the other hand, our results show that small
firms issue equity and raise up cash holdings despite having low leverage. Lemmon and
Zender (2004) provides a justification for equity issuances that equity issuers are prevented
from issuing debt because of concerns over financial distress or to preserve financial slack
for future investment. Further, Fama and French (2002) and Leary and Roberts (2005a)
show that firms are more likely to use equity financing as investment increases and/or cash
flow decreases but the majority of equity financings occur when firms still have sufficient
debt capacity to fill their investment needs. However, small firms in our sample appear to
issue equity and build up cash holdings in order to cope with abnormal earnings shortfalls
rather than to preserve financial slack.
As an alternative explanation for violating the financing hierarchy, Fama and French
(2005) and Leary and Roberts (2005a) suggest that firms are able to issue securities in
a manner that avoids the adverse selection costs associated with information asymmetry.
Alternatively, managers may time the market when information asymmetry, and the corresponding costs, are low so that deviations from the hierarchy do not incur a significant
penalty.6 Our findings suggest that the external financing hierarchy suggested by the pecking order theory is revered due to the concern for financial flexibility. Consistent with our
evidence, Byoun (2006a) finds that small debt-free firms raise much external equity while
reducing debt and paying large dividend. Thus, financial flexibility can bear more important relevance to capital structure decisions than the adverse selection costs of asymmetric
(2003), and Lemmon and Zender (2004) under the pecking order framework, and Frank
and Goyal (2003), Fama and French (2002), Barclay and Smith (2005), Leary and Roberts
(2005), Leary and Roberts (2005a), Strebulaev (2006) and Byoun (2006) under the tradeoff
framework.
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Rajan and Zingales (1995), Jung, Kim, and Stulz (1996), Pagano, Panetta, and Zingales
(1998), Hovakimian, Opler, and Titman (2001), Baker and Wurgler (2002), and Leary
and Roberts (2005a)) examine managers’ market-timing attempts. The survey results in
Graham and Harvey (2001) suggest that managers issue equity following an increase in
stock price.
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information.
Our findings suggest that small firms have lower leverage ratios, not because of internally
generated funds or additional debt financing (as implied by the pecking order theory) but
because of additional equity financing (consistent with our financial flexibility hypothesis).
Small firms build up cash holdings in order to preserve financial flexibility through external
equity. Overall, asymmetric information falls short of providing a complete explanation for
motivation behind firms’ external financing decisions. An alternative explanation should
include the benefits and costs of financial flexibility, which may require a substantial alteration to the tradeoff argument which is based only on traditional costs and benefits of
taxes, bankruptcy costs, agency costs, and transaction costs.
II. The Concept of Financial Flexibility: A Literature Review
The pecking order theory by Myers and Majluf (1984) assumes that firms desire
to maintain “financial slack” to avoid the need for external funds. However, finding that
managers value financial flexibility is not sufficient to prove that the pecking-order model
is the true description of capital structure choice (Opler et al., 1999). Graham and Harvey
(2001) make this point explicit:
The most important item affecting corporate debt decisions is management’s
desire for “financial flexibility,”... However, the importance of flexibility in the
survey responses is not related to informational asymmetry (size or dividend
payout) or growth options in the manner suggested by the pecking-order theory.
In fact, flexibility is statistically more important for dividend-paying firms, opposite the theoretical prediction (if dividend-paying firms have relatively little
informational asymmetry). Therefore, a deeper investigation indicates that the
desire for financial flexibility is not driven by the factors behind the peckingorder theory.
Despite managers’ contention that financial flexibility is an important factor in the
decision-making process of managers, the capital structure literature has to date remained
aloof to recognize and incorporate financial flexibility. Frank and Goyal (2005) reason, “the
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stress on financial flexibility is interesting, but potentially open to a variety of interpretations. In our view the survey evidence is of interest, but it is best regarded as being
interesting and suggestive, rather than providing definitive tests.” In addition to considerable ambiguity in the use of the term, judgments about flexibility are subjective and
informal and flexibility levels are rarely monitored or even measured. Accordingly, dealing
with financial flexibility may be criticized as being less than practical and based on speculation on the ability of a firm to respond to hypothetical future events. It is therefore not
surprising that there is relatively little systematic study of financial flexibility in the capital
structure literature.7
Graham Harvey (2001) see financial flexibility as “preserving debt capacity to make
future expansions and acquisitions” or “minimizing interest obligations, so that they do not
need to shrink their business in case of an economic down turn.” Gamba and Triantis (2005),
in their attempt to model the value of financial flexibility, define, financial flexibility as “the
ability of a firm to access and restructure its financing with low transaction costs.” They
further elaborate by adding “financially flexible firms are able to avoid financial distress in
the face of negative shocks, and to fund investment at low cost when profitable opportunities
arise.” Donaldson (1969, 1971) uses “financial mobility” to describe “the capacity to redirect
the use of financial resources in a manner consistent with the evolving goals of management
as it responds to new information about the company and its environment.” Donaldson
particularly relates financial mobility to capital structure decisions where the goal is to find
the optimal mix of financing sources.
Heath (1978) describes financially flexible company as one that can take corrective action
that will eliminate an excess of required cash payments over expected cash receipts quickly
and with minor adverse effect on its present and future earnings or on the market value of
its stock. The American Institute of Certified Public Accountants (AICPA, 1993) adopts
Heath’s view by defining financial flexibility as “the ability to take action that will eliminate
7
In contrast, a branch of real options literature has been developed to deal with “investment flexibility.” Gamba and Triantis (2005) note that most real options models are
designed to measure the value of “investment flexibility” under the assumption of perfect
“financial flexibility.”
6
an excess of required and expected cash payments over expected resources.” The Financial
Accounting Standards Board’s (FASB) defines financial flexibility as “the ability of an
entity to take effective actions to alter amounts and timing of cash flows so it can respond
to unexpected needs and opportunities.” Most of the treatments of financial flexibility in
the finance literature are more or less about the ability of a firm to meet its expected future
needs through large cash flow, large unused borrowing capabilities, or large liquid assets.
The importance of flexibility in a firm is well recognized in management and organization
literature. Bueno-Campos (1992), Ahmed et al. (1996), Albizu-Gallastegui (1997), Hitt et
al. (1998) and Volberda (1998) define “flexibility” as the ability to deliver cost-efficient
responses quickly to changes in the business environment and to adapt and anticipate
changes that affect the goals of firms. There are other views from different functional
areas of business (See Koornhof (1998) for a more detailed review on this). For example,
Pasmore (1994) view humans are the drivers of organization flexibility. Harrigan (1985)
use the term “strategic flexibility” to refer to a firm’s ability to reposition itself in markets,
change its game plan or dismantle its current strategies. Trigeorgis (1993) and Kulatilaka
(1993) use the term “operating flexibility” to describe the ability of managers to revise
operating decisions in response to favorable opportunities or deteriorating conditions. This
includes switching from one project to another. Such operating options are critical when
the environment is highly volatile and technology is flexible, thus permitting managerial
intervention at little cost.
Bernstein (1993) defines flexibility as the ability of an enterprise to take steps to counter
unexpected interruptions in the flow of funds for reasons however unexpected. In this view,
financial flexibility means the ability to borrow from a variety of sources, to raise equity
capital, to sell and redeploy assets, and to adjust the level and the direction of operations in
order to meet changing circumstances. Koornhof (1998) defines flexibility as an ability to
take actions to reposition the resources and functions of the organization to new information
and environment in a manner consistent with the evolving vision, strategies and goals of
management.
The definitions of flexibility as addressed in the management and organization litera-
7
tures recognize the “reactive” and “preventive” nature of flexibility while failing to include
the “exploitive” nature of flexibility for uncertain competitiveness or environment. The
combination of reactive, preventive, and exploitive nature of flexibility is more evident in
Volberda (1998) who views flexibility in two different perspectives: internal flexibility as
the firm’s capacity to adapt to the demands of the environment, while external flexibility
as the firm’s capacity to influence their environment and thereby reduce their vulnerability.
Following the Volberda’s (1998) notion of flexibility, we propose to regard the financial
flexibility not as the passive accumulation of resources but as the degree of capacity and speed
at which the firm can mobilize its financial resources in order to take reactive, preventive and
exploitive actions to maximize the firm value. The choice of financial flexibility is pragmatic
and avowedly relativistic; it is chosen because of its ability to bring the diverse uses of
flexibility into meaningful comparative relationships. Actions initiated ahead of time are
typically taken in anticipation of certain events, or in an attempt to change the rules of the
game. When expectations are not met, or when events occur that have not been predicted,
a firm may require flexibility after the fact. In these cases, attempts are made to correct a
mistake or to capitalize on an unexpected opportunity. The point to note is that actions
taken ahead of time, even in the absence of a specific goal, can create options that can be
used at a later stage. When a new product unexpectedly becomes an industry standard (e.g.,
Apple’s iPod), resulting in a rapid expansion of the market demand, exploitive maneuvers
are important to focus resources and to rapidly capitalize on spontaneous opportunities. The
speed is critical. According to our definition, financial flexibility is a function of uncertainty;
not just about future cash flows but also about organization and environment. If the
business environment is more turbulent and competitive (development stage in the life
cycle), there will be more demand for flexibility to cope the uncertainty. Flexibility arises
from a formal decision problem in which the choice from future options are affected by the
choice made now (Gerwin, 1993). In other words, the decision on flexibility made in the
present impacts on the options management will have available in the future in response
to unforeseeable change. Financial flexibility is future oriented. It would be fundamentally
inappropriate of a CFO of a company to say that his or her job is to maximize flexibility for
8
the organization. Thus, maximizing the firm value should be the ultimate goal of optimizing
financial flexibility.
It is apparent that certain aspects of financial flexibility have been addressed in the
literature. For example, Goldstein, Ju, and Leland (2001) note that a firm with low leverage
today preserves the subsequent option to increase leverage. Byoun (2006) find evidence that
firms preserve borrowing capacity to finance future investment or growth opportunities.
Graham (2000) shows that firms preserve debt capacity to make future expansions and
acquisitions. Motyka, Leuca, and Fawson (2005) also find that financial institutions hold
excess liquidity to cope with the unpredictable nature of loss (infrequent but high impact
risk) in order to achieve a competitive advantage for aggressive pricing and better margins.
III. Financial Flexibility and Leverage: the Hypotheses
DeAngelo and DeAngelo (2006) note that firms can develop potential sources of
future financial flexibility through cash accumulation, the preservation of debt capacity, and
equity payouts. According to their argument, in “normal” periods, mature firms maintain
low leverage and high payouts, thus preserving the firm’s option to borrow or issue equity in
the future while limiting agency costs on cash balances. In “abnormal” periods characterized
by unanticipated earnings shortfalls or profitable new investment opportunities, the firm
issues securities, either debt or equity, depending on the trade-off between benefits and
costs of issuing now versus preserving the option for the future. Thus, in view of financial
flexibility, change in profit (especially loss) can be important determinant of leverage.
We identify firms in those “abnormal” periods of unanticipated earnings shortfalls according to retained earnings. Retained earnings are accumulation of firms’ reinvested profits
over time. Negative retained earnings reflect firms’ earnings shortfalls over time. Even a
little debt may cause firms with negative retained earnings to be in financial distress. The
limitation on debt issuance that results from the risk of asset substitution (Jensen and
Meckling (1976)) are more important for firms with negative retained earnings. Firms with
negative retained earnings lack investible funds for their profitable investments and hence
sources of free cash flow tend to be relatively less for them, and thus reducing the ben-
9
efit of debt that limits the scope of overinvestment and perquisites by managers (Jensen
(1986), Stulz (1990) and DeAngelo and DeAngelo (2006)). Hence the benefits of debt are
less helpful both in terms of the sources and uses of free cash flow. Another benefit to the
use of leverage is its signal to the market about the quality or riskiness of the firm (Ross
(1977), Leland and Pyle (1977), and Heinkel (1982)). However, debt financing renders firms
with negative earnings vulnerable to predatory strategies such as price wars by established
firms to exhaust vulnerable firms financially (Poitevin (1989)), thus deteriorating financial
flexibility. In addition, debt covenant often carry restrictions on financing and investment
decisions that are especially cumbersome for small, growing firms. Accordingly, small firms
with negative retained earnings have little incentive to use leverage to signal their quality.
Overall, small firms with negative retained earnings are likely to have little financial
flexibility and debt capacity but ample needs for additional cash. On the other hand,
equity issues neither require collateral or restrictive covenants, nor accentuate moral hazard
problems that are associated with leverage, nor raise the probability of financial distress.
Thus, our main hypothesis is that firms with negative retained earnings are more likely to
issue equity than debt and have low leverage than firms with positive retained earnings.
We also hypothesize that small firms’ lower leverage can be explained by financial flexibility
consideration.
A firm can also develop financial flexibility through cash accumulation (DeAngelo and
DeAngelo (2006)). On the one hand, cash holdings increase financial flexibility. On the
other hand, it increases agency costs. Leverage can mitigate agency costs, but leverage
in turn reduces future financial flexibility. As noted above, firms with negative earnings
are likely to be in need of financial flexibility while constrained in borrowing and with
little concern for agency costs and thus they can accumulate cash holdings through equity
financing in order to preserve financial flexibility. Accordingly, we expect that cash holdings
are negatively associated with leverage ratios.
II. Data
The initial sample consists of all available U.S. firms for the period of 1971–2005
from the annual Compustat files. Following previous studies, we exclude financial firms and
10
regulated utilities from the sample.8 We also require firms to have positive total assets,
book and market value of equity and net sales. These variables are used to deflate other
variables and it is difficult to interpret the results when they have non-positive values.
We also delete observations with missing or non-positive values for the number of shares
outstanding (Compustat item 25) and stock price at the end of the fiscal year (item 199).
Accordingly, we drop bout 8 % of firm-year observations in the sample that have non-positive
total assets market value of equity or net sales. After these requirements are applied, the
sample consists of 179,418 firm-year observations.
While Shyam-Sunder and Myers (1999) and Myers (1984) argue that there are rational
reasons for managers to specify debt targets in terms of book values, Titman and Wessels
(1988) and Welch (2004) are inclined toward the use of debt level measured at market value.
Accordingly, we estimate the models using total (item 9 + item 34) and long-term (item 9)
debt ratios measured with both book and market value of total assets.
III. Estimation and Results
A. Firm Size and Leverage
In order to examine the relationship between firm size and leverage, we divide the sample into size deciles each year and report the leverage ratios measured in long-term and total
debt to book/market value of assets. The market value of assets equals total assets (item 6)
minus total equity (item 216) minus balance sheet deferred taxes and investment tax credit
(item 35) plus the market value of common equity (price (item 199) times shares outstanding (item 54)) plus preferred stock liquidating value (item 10, replaced by the redemption
value of preferred stock (Item 56) when missing).9 We delete all observations with leverage
8
Financial firms are represented by SIC codes 6000-6799 and utilities by SIC codes 48004999. These firms have very different capital structures and their financing decisions may
not convey the same information as non-financial and non-regulated firms. For example, a
relatively high leverage ratio is normal for financial firms, but the same high leverage ratio
for non-financial firms may indicate possible financial distress.
9
The results does not change when we exclude deferred taxes and investment tax credit
or include convertible debt (item 79) in the definition of book equity as in Alti (2006) and
Kayhan and Timan (2006).
11
ratios less than zero or greater than one.10 We define size in three different ways based on
book value of total assets (item 6), market value of total assets and net sales (item 12), but
the results are similar and we report only those based on the book value of total assets.
Table I
Panel A of Table I shows that regardless of the various definitions of leverage ratios,
there is a positive relationship between firm size and leverage ratio especially for smaller
size deciles. However, the positive relationship between firm size and leverage is not clear
for firms in the largest three deciles. We also report the percentage of zero-debt firms in
each size decile. Small firms are associated with much more zero-debt firms than large firms.
Byoun (2007) suggests that zero-debt firms are constrained by debt market while unconstrained by equity market. In order to examine whether the negative relationship between
firms size and leverage is driven by these zero-debt firms, we report the results excluding
zero-debt firms in Panel B of Table I. Even though the leverage ratios of small firms increase
without the zero-debt firms, the positive relationship between size and leverage ratio are
still present for smaller size deciles. Thus, our results confirm that there exists fairly strong
positive relationship between firm size and leverage except for firms in the largest three
deciles in which the positive relationship is weakened or reversed.
Table II
Faulkender and Petersen (2006) argue that market frictions may cause firms to be
rationed by their lenders, leading some firms to appear under-levered relative to unconstrained firms. Thus, when estimating a firm’s leverage, it is important to include not only
10
Without this requirement, the average book leverage ratio of the sample firms in the
first size decile are greater (but market leverage ratios are smaller) than firms in larger size
deciles since there are a few firms with book leverage ratios greater than one in the first
size decile. When we winsorize leverage ratios at 99 percentile, there still exist firms with
leverage ratios greater than one.
12
determinants of its desired leverage (the demand side) but also variables that measure the
constraints on a firm’s ability to increase its leverage (the supply side). Following Faulkender
and Petersen (2005) and Lemmon and Zender (2004) we use firms’ long-term credit ratings
(item 280) as a measure of accessibility to the public debt markets. Rating information is
available only from 1985. Accordingly we divide the sample into two subperiods into before
and after 1985, which also allows us to examine any discernable change in the relationship
between firm size and leverage. For the period of 1971-1984, the relationship between firm
size and leverage is positive and monotonic, whereas the relationship is weak or negative for
firms in the largest three deciles for the period of 1985-2005. The results show that small
firms rarely have long-term credit ratings and most ratings are concentrated in the largest
three deciles. The lack of available credit ratings for small firms may indicate that these
firms have relatively less debt capacity and hence lower leverage.
Our results explain why Faulkender and Petersen (2006) find a negative relationship
between leverage and firm size. The sample in Faulkender and Petersen (2006) includes
only firms with credit ratings that are mainly from the largest size deciles for the period
since 1985 and these firms show a weak or negative association between firm size and
leverage.
B. Firm Size, Cash Holdings, Retained Earnings and External Financing Activities
In order to examine weather the lower leverage for small firms results from accumulated
internal equity (as suggested by the pecking order theory) or external equity (as suggested
by the financial flexibility hypothesis), we report retained earnings (item 36), net long-term
debt issue (item 111 - item 114), net total debt issue (item 111 − item 114 − item 301
if item 318 = 1 and item 111 − item 114 + item 301, otherwise)11 and net new equity
issue (item 108 - item 115) as proportions of total assets. We also examine the ratio of
11
Changes in current debt (item 301) represent an increase in working capital for format
code 1 but a decrease in working capital for format codes.
13
cash and marketable securities to total assets ([item 162 + item 193] / item 6)12 . We drop
observations with missing values in any of the reported variables.
Table III
Table III reports the results. The results in Panel A show that small firms tend to
have more cash holdings while having less retained earnings than large firms. In fact, the
average retained earnings are negative for firms in smaller size deciles. Thus, small firms’
growth is not likely to come mainly from internal equity. Small firms’ long-term or total
debt financing is miniscule compared to that of large firms. On the other hand, small firms’
equity financing is phenomenal. The firms in the first and second size deciles issue equity
on annual average 25% and 12% respectively of total assets.
Our results can be driven by IPO firms that are more likely to be in small size deciles. In
order to examine the IPO effects, we identify the IPO date from Compustat and designate
the first fiscal year ending after the IPO date as a IPO year. We also identify the first year
appearing in the Compustat for those that do not have IPO dates but the Computat begins
its coverage during our sample period and treat it like the IPO year. The results excluding
these IPO years are reported in Panel B. They show that the magnitude of external equity
raised by small firms become smaller without IPO years, but it is still significantly greater
than that raised by larger firms.
Another possibility is that the results could be driven by a few outliers especially in
small size deciles. To address this concern we reproduce results with winsorization of the
equity financing variable at 1st and 99th percentiles. Again the results in Panel C show
the same result that the small firms heavily rely on external equity with little debt. The
pattern remains intact but only with less magnitudes when we winsorize the variable with
greater cutoff percentiles.
Overall, firm size is negatively associated with cash and debt financing whereas positively
12
Including accounts receivable (item 2) in addition to cash and marketable securities
produces almost identical results.
14
associated with retained earnings, equity issue and dividend payout ratio. Thus, small firms
appear to have lower leverage ratios, not because of internally generated funds or additional
debt financing but because of additional equity financing. Small firms also build up cash
holdings in order to preserve financial flexibility through external equity.
C. Firm Size, Retained Earnings and Leverage
In order to disentangle the relationship between firm size and leverage ratios while
accounting for the strong association of firm size with retained earnings, we first examine
the leverage ratios for firms divided into negative and positive retained earnings groups
within each size decile.
Panel A of Table IV shows cash holdings, dividend, and leverage ratios for each group.
Interesting is the finding that the smaller firms (in size deciles below 6) with negative
retained earnings hold more cash balances than similar size firms with positive retained
earnings probably as a means of preserving financial flexibility. On the other hand, large
firms with negative retained earnings tend to carry less cash balances with higher leverage
ratios than large firms with positive retained earnings. The market value leverage ratios
for firms with negative retained earnings are always smaller than book value leverage ratios
because negative retained earnings increase market value of total assets when we subtract
total equity from total assets to replace with the market value of equity. Since the portion
of negative retained earnings relative to total assets are significantly greater for small decile
firms, smaller firms (in 1 to 4 size deciles) with negative retained earnings have higher book
leverage ratios whereas lower market-value leverage ratios than firms with positive retained
earnings in the same size deciles. Thus, firms with negative retained earnings appear to
have higher book leverage ratios because of less total assets stemming from negative retained
earnings. The results suggest that the relationship between firm size and leverage within
smaller size deciles (less than decile 5) can depend on whether the leverage is measured
in terms of book or market value because of the significant number of firms with negative
retained earnings. Firms with positive retained earnings pay higher dividend than firms
with negative retained earnings. Thus, there are important differences between positive
15
and negative retained earnings groups.
Panel B of Table IV shows that firms with negative retained earnings issue much more
equity than those with positive retained earnings. The larger equity issues of small firms
are driven by firms with negative retained earnings as they issue equity to raise cash while
maintaining financial flexibility. This finding is consistent with our hypothesis that small
firms with negative retained earnings issue equity rather than debt to preserve financial
flexibility. Larger firms with negative retained earnings tend to issue both debt and equity,
but their equity issues are significantly greater than those of large firms with positive retained earnings.
Table IV
D. Regression Results
We first estimate regressions with variables typically used in previous cross-sectional
studies as well as additional variables we expect to have significant impacts on leverage
ratios. The following firm and industry characteristic variables are included:
Retained = retained earnings divided by total assets;
N egRet = dummy variable equal to one for the year with negative retained earnings and
zero otherwise;
Zero = dummy variable equal to one for the year with zero debt and zero otherwise;
IP O = dummy variable equal to one for IPO year and zero otherwise;
Cash = Cash and equivalents divided by total assets;
M ed = industry median debt ratio (based on two-digit SIC or Fama and French (2002)
industry groupings). According to Frank and Goyal (2004), the industry median
leverage is an important determinant of a firm’s leverage ratio, acting as a proxy for
several factors, including intangibility, regulation, stock variance, uniqueness, purchasing manager’s sentiment index, etc.;
16
T ax = marginal tax rate equal to the statutory tax rate if the firm reports no net operating
loss carryforwards (item 52) with positive pretax return (item 170) and zero otherwise.
The statutory taxes are 48% from 1971 to 1978, 46% from 1979 to 1986, 40% in 1987,
34% from 1988 to 1992, and 35% from 1993 to 2003. Plesko (2003) shows that this
binary measure captures the marginal tax effects;
OI = operating income (item 13) divided by total assets (item 6). A firm with higher
earnings could prefer to operate with either lower or higher leverage. Lower leverage
might occur, as higher retained earnings mechanically reduce leverage, or if the firm
limits leverage to protect the franchise responsible for producing these high earnings.
Higher leverage might reflect the firm’s ability to meet debt payments out of its
relatively high earnings cash flow;
M B = market-to-book ratio of assets.13 A higher M B is generally taken as a sign of more
attractive future growth options, which a firm tends to protect by limiting its leverage;
LnA = log of total assets (item 6) as a measure of firm size. Larger firms tend to: have more
leverage (perhaps because they are more transparent); have lower asset volatility; or
naturally sell large enough debt issues so that the fixed costs of public borrowing are
not prohibitive;14
DEP = depreciation and amortization (item 14) as a proportion of total assets. Firms
with more depreciation expenses have less need for the interest deductions associated
with debt financing;
F A = fixed assets (item 8) divided by total assets. Firms operating with greater tangible
assets have a higher debt capacity;
13
The results do not change when we exclude deferred taxes and investment tax credit
or include convertible debt (item 79) in the definition of book equity (as in Alti (2006) and
Kayhan and Titman (2006)).
14
The results are not affected whether the size is defined in terms of market value of
assets or of net sales (item 12).
17
RN D = research and development expenditures (item 46) divided by net sales (item 12).
RN D can be taken as a proxy for future expected investment (Fama and French
(2002)). They also serve as an additional proxy for non-debt tax shields. We set
missing values as zero and include a dummy variable;
D RN D = dummy variable that equals one for firms with missing RN D and zero otherwise;
DIV = common stock dividends (item 127) divided by total assets. DIV controls for
possible trade-off between debt and dividend in reducing agency costs of free cash
flow (Fama and French (2002)); and
AZ = Altman’s Z-score modified by MacKie-Mason (1990): (3.3EBIT (item 178) + sales
(item 12) + 1.4 retained earnings (item 36) + 1.2 working capital (item 4 - item 5))
divided by total assets. Altman’s Z-score measures the ex ante probability of distress
(Graham (1996, 2000)).
We winsorize all the variables deflated by total assets at the 1st and 99th percentiles
except for industry median (M ed), dividend (DIV ), and R&D (RN D) which are winsorized
only at the 99th percentile because many firms have a value of zero for these variables.
Table V reports two sets of estimation results for each dependent variable, with and
without variables N egRet, Zero, IP O, and Cash. These additional variables are not
frequently used in previous studies and we want to see if the results are different when they
are included. The coefficient estimates on firm size (LnA) are highly significant and positive
in all regressions. Thus, there is a fairly strong positive relationship between leverage and
firm size even after controlling for the additional variables. All the other coefficient estimates
are significant with the same signs found in previous studies. When we include N egRet,
Zero, IP O and Cash, the coefficient estimates on these variables are negative. This result
suggests that firms with negative retained earnings have significantly lower leverage. Also,
firms holding more cash balances tend to have lower leverage.
In order to further examine the effect of retained earnings on the relationship between
firm size and leverage, we divide the firm into four groups: large/small firms (deciles greater
than/less than or equal to 5) with positive/negative retained earnings. The reasons we
18
divide firms this way are that the effect of negative retained earnings could be different
between small and large firms and that in our previous results the relationship between
leverage and firm size is rather ambiguous for larger firms. We run the same regressions as
in Table V for these subgroups except that we replace the negative retained earnings dummy
variable with retained earnings (Retained) winsorized at the 1st and 99th percentiles.
The estimation results are reported in Table VI. The results show that the coefficient
estimates on size (LnA) tend to be positive for small firms (in Panels A and B) but negative
or insignificant for large firms (in Panels C and D). Thus, the positive relationship between
firm size and leverage holds true only for small firms. This finding is consistent with
the univariate results that show lower leverage ratios for the largest decile firms. The
coefficient estimates on retained earnings (Retained) are highly significant and negative for
firms with positive retained earnings (in Panels A and C), whereas they are economically or
statistically insignificant for firms with negative retained earnings (in Panels B and D). As
we observed in Table IV, the effects of negative retained earnings are different between book
and market value leverage ratios: negative retained earnings lower the book leverage, which
results in small negative coefficient estimates on retained earnings in book-value-leverageratio regressions; and negative retained earnings increase the market value leverage, which
results in small positive or insignificant coefficient estimates on retained earnings in marketvalue-leverage-ratio regressions.
Overall, our results suggest that the positive relationship between leverage and firm size
hold for small firms but not for large firms when we control for retained earnings which
measures the degree of financial flexibility. The firm size up to a certain level appears
to be important for leverage but its importance disappears once firms outgrow that level.
Small firms’ lower leverage ratios appear to result from their concern for financial flexibility
(issuing equity and building up cash holdings) and large firms with positive retained earnings
also have lower leverage as they accumulate internal funds to preserve financial flexibility
or to finance growth opportunities. Thus, the relationship between leverage and firm size
appears to be positive for small firms but negative for large firms.
19
VI. Summary and Conclusions
We examine the relationship between firm size and leverage in the view of financial
flexibility. We define financial flexibility as the degree of capacity and speed at which the
firm can mobilize its financial resources in order to take reactive, preventive and exploitive
actions to maximize the firm value. We hypothesize that firms with negative retained
earnings are likely to have little financial flexibility and debt capacity but ample needs
for additional cash. Accordingly, firms with negative retained earnings are more likely to
issue equity to build up cash holdings (a means of financial flexibility) and hence have low
leverage. The corollary to this hypothesis is that cash holdings will be negatively associated
with leverage. We also examine if we can explain the positive relationship between firm size
and leverage in the view of financial flexibility, given that many small firms have negative
retained earnings and are in need of financial flexibility.
Consistent with our hypothesis, firms with negative retained earnings issue several times
more equity than firms with positive retained earnings. While small firms avoid debt financing, they are much more active in tapping into external equity capital. We also find
that small firms often have negative retained earnings with no less cash holdings than other
firms and that small firms with negative retained earnings have lower leverage than firms
with positive retained earnings.
We further show that firm size has an overall strong and significant positive association with leverage. However, the positive relationship between firm size and leverage are
substantially weakened or reversed for large firms when we control for retained earnings.
Our regression results, coupled with univariate results, suggest that small firms with negative retained earnings build up cash holdings through equity financing, lowering leverage
ratios, whereas large firms with positive retained earnings accumulate earnings (as a means
of building financial flexibility), resulting in lower leverage ratios. Thus, the relationship
between leverage and firm size is unclear—we need more research on this issue. Overall,
small firms appear to have lower leverage ratios, not because of internally generated funds
or additional debt financing but because of additional equity financing. Small firms also
build up cash holdings in order to preserve financial flexibility through external equity.
20
This finding can be explained by neither of the pecking order theory and the tradeoff
theory—the pecking order may be reversed for small firms that prefer external equity to debt
financing while the tradeoff theory may miss out some important aspects of capital structure
decisions. In conclusion, the benefits and costs associated with financial flexibility influence
firms’ capital structure decisions—but not in the manner hypothesized by the traditional
trade-off theory. Thus, a substantial alteration may be required to the tradeoff argument
which is based only on traditional costs and benefits of taxes, bankruptcy costs, agency
costs, and transaction costs.
21
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27
Table I. Firm Size Deciles and Leverage Ratios
The data consists of 179,418 firm-year observations for the period 1971-2005. Observations with missing values in any of
the reported variables are deleted. Size is size deciles based on total assets. Book /Market Long-term/Total Debt is longterm/total debt over book/market value of total assets. The market value of assets equals total assets minus total equity
minus balance sheet deferred taxes and investment tax credit plus the market value of common equity plus preferred stock
liquidating value. % of Firms with Zero Debt is the percentage of firms relative to the total number of firms in each size
decile. A zero-debt firm is a firm with no debt.
A. All firm-year observations (179,418)
Size Decile
1
2
3
4
5
6
7
8
9
10
Total Assets
3.62
10.39
21.66
40.62
71.75
128.62
240.64
496.17
1354.40
15673.95
Book Longterm Debt
0.0974
0.1241
0.1356
0.1452
0.1651
0.1916
0.2188
0.2437
0.2476
0.2387
Book Total
Debt
0.2074
0.2184
0.2186
0.2170
0.2286
0.2493
0.2725
0.2942
0.2968
0.3017
Market Longterm Debt
0.0590
0.0943
0.1137
0.1295
0.1482
0.1687
0.1890
0.2089
0.2125
0.2138
Market Total
Debt
0.1164
0.1647
0.1828
0.1936
0.2062
0.2217
0.2378
0.2537
0.2552
0.2679
Book Total
Debt
0.2604
0.2593
0.2568
0.2547
0.2626
0.2768
0.2944
0.3079
0.3060
0.3036
Market Longterm Debt
0.0741
0.1120
0.1335
0.1520
0.1702
0.1873
0.2042
0.2187
0.2190
0.2151
Market Total
Debt
0.1462
0.1955
0.2147
0.2273
0.2368
0.2461
0.2569
0.2655
0.2630
0.2696
B. Non-zero-debt firm-year observations (155,435)
Size Decile
1
2
3
4
5
6
7
8
9
10
Total Assets
3.67
10.26
21.17
39.21
68.78
123.99
237.02
490.26
1347.74
15694.31
Book Longterm Debt
0.1223
0.1474
0.1593
0.1704
0.1896
0.2127
0.2364
0.2550
0.2553
0.2402
% of Firms
with Zero
Debt
0.2035
0.1578
0.1487
0.1480
0.1293
0.0994
0.0744
0.0445
0.0299
0.0063
Table II. Firm Size Deciles and Leverage Ratios for Sub-periods Divided into Before and After 1985
The data consists of firm-year observations for the period 1971-2005. Observations with missing values in any of the
reported variables are deleted. Size is size deciles based on total assets. Book /Market Long-term/Total Debt is longterm/total debt over book/market value of total assets. The market value of assets equals total assets minus total equity
minus balance sheet deferred taxes and investment tax credit plus the market value of common equity plus preferred stock
liquidating value. % of Firms with Zero Debt is the percentage of firms with no debt relative to the total number of firms
in each size decile. % of Firms with Bond Rating is the percentage of firms with long-term credit ratings relative to the
total number of firms in each size decile.
A. For 1971 – 1984 Period (53,702 Obs)
Size Decile
1
2
3
4
5
6
7
8
9
10
Total
Assets
4.19
9.75
17.06
27.68
44.14
71.33
122.58
239.36
631.22
4276.30
Book Longterm Debt
0.1132
0.1481
0.1727
0.1923
0.2035
0.2193
0.2315
0.2326
0.2470
0.2505
Book Total
Debt
0.2046
0.2350
0.2552
0.2695
0.2750
0.2873
0.2941
0.2893
0.3008
0.3044
Market
Long-term
Debt
0.0873
0.1345
0.1658
0.1939
0.2031
0.2189
0.2293
0.2322
0.2488
0.2638
Market
Total Debt
0.1525
0.2123
0.2453
0.2719
0.2754
0.2880
0.2926
0.2884
0.3016
0.3172
% of Firms
with Zero
Debt
0.1734
0.1034
0.0812
0.0594
0.0540
0.0352
0.0374
0.0239
0.0121
0.0019
Book Total
Debt
0.2087
0.2110
0.2023
0.1934
0.2078
0.2323
0.2628
0.2963
0.2950
0.3005
Market
Long-term
Debt
0.0463
0.0763
0.0903
0.1006
0.1236
0.1461
0.1709
0.1985
0.1962
0.1914
Market
Total Debt
0.1003
0.1433
0.1548
0.1586
0.1751
0.1920
0.2133
0.2382
0.2343
0.2458
% of Firms
with Zero
Debt
0.2170
0.1822
0.1790
0.1877
0.1631
0.1282
0.0910
0.0538
0.0379
0.0083
B. For 1985 – 2005 Period (119,813)
Size Decile
1
2
3
4
5
6
7
8
9
10
Total
Assets
3.36
10.67
23.72
46.41
84.14
154.28
293.57
611.28
1678.72
20778.29
Book Longterm Debt
0.0903
0.1134
0.1190
0.1241
0.1479
0.1792
0.2131
0.2486
0.2479
0.2334
% of Firms
with Credit
Rating
0.0000
0.0004
0.0006
0.0022
0.0128
0.0551
0.1533
0.3279
0.5758
0.7800
Table III. Firm Size Deciles, Cash Holdings, Retained Earnings and External Financing Activities
The data consists of firm-year observations for the period 1971-2005. Observations with missing values in any of the
reported variables are deleted. Size deciles are based on total assets. All the variables are reported as a proportion of total
assets.
A. All firm-year observations (173,515)
Size Decile
1
2
3
4
5
6
7
8
9
10
Cash and
Equivalents
0.4141
0.4012
0.3989
0.3958
0.3725
0.3475
0.3157
0.2784
0.2469
0.2195
Retained
Earnings
-3.8807
-0.8725
-0.4103
-0.1390
0.0244
0.0961
0.1656
0.1940
0.1995
0.2102
Net Longterm Debt
Issue
0.0023
0.0024
0.0007
0.0013
0.0044
0.0103
0.0174
0.0219
0.0219
0.0163
Net Total
Debt Issue
-0.0004
0.0027
0.0025
0.0024
0.0059
0.0113
0.0183
0.0229
0.0227
0.0172
Net New
Equity Issue
0.2527
0.1164
0.0852
0.0777
0.0604
0.0453
0.0273
0.0158
0.0082
0.0017
Dividend
0.0077
0.0068
0.0078
0.0083
0.0093
0.0097
0.0117
0.0136
0.0170
0.0193
Net Longterm Debt
Issue
0.0010
0.0015
0.0007
0.0038
0.0066
0.0125
0.0174
0.0218
0.0212
0.0160
Net Total
Debt Issue
-0.0016
0.0019
0.0030
0.0056
0.0084
0.0140
0.0183
0.0228
0.0219
0.0168
Net New
Equity Issue
0.1744
0.0771
0.0495
0.0357
0.0283
0.0230
0.0153
0.0096
0.0046
0.0004
Dividend
0.0083
0.0069
0.0074
0.0073
0.0082
0.0092
0.0111
0.0132
0.0164
0.0193
B. Non-IPO firm-year observations (154,156)
Size Decile
1
2
3
4
5
6
7
8
9
10
Cash and
Equivalents
0.4033
0.3945
0.3910
0.3797
0.3615
0.3426
0.3146
0.2791
0.2473
0.2187
Retained
Earnings
-4.4562
-0.9800
-0.4492
-0.1444
0.0281
0.1029
0.1742
0.2003
0.2047
0.2120
C. Non-IPO firm-year observations with winsoriation at 1 and 99 percentiles (151,058)
Size Decile
1
2
3
4
5
6
7
8
9
10
Cash and
Equivalents
0.3976
0.3880
0.3870
0.3776
0.3599
0.3411
0.3140
0.2784
0.2469
0.2181
Retained
Earnings
-3.4280
-0.8900
-0.4281
-0.1393
0.0276
0.1017
0.1723
0.1979
0.2032
0.2111
Net Longterm Debt
Issue
0.0025
0.0019
0.0010
0.0037
0.0064
0.0119
0.0168
0.0214
0.0206
0.0156
Net Total
Debt Issue
0.0017
0.0027
0.0040
0.0057
0.0084
0.0134
0.0177
0.0224
0.0212
0.0164
Net New
Equity Issue
0.0743
0.0541
0.0432
0.0346
0.0289
0.0248
0.0177
0.0122
0.0073
0.0021
Dividend
0.0086
0.0067
0.0073
0.0072
0.0081
0.0091
0.0110
0.0131
0.0163
0.0193
Table IV. Firm Size Deciles, Retained Earnings, Leverage, Financing Activities
The data consists of firm-year observations for the period 1971-2005. Observations with missing values in any of the
reported variables are deleted. Size deciles are based on total assets. Firms are divided into positive and negative retained
earnings groups within each size decile. All the variables are reported as a proportion of total assets.
A. Cash Holdings and Leverage
Size
Decile
1
1
2
2
3
3
4
4
5
5
6
6
7
7
8
8
9
9
10
10
Total
Retained
Earnings
-5.2296
0.3082
-1.7479
0.3014
-1.2568
0.2991
-0.8691
0.2892
-0.6213
0.2934
-0.5084
0.2899
-0.4025
0.2968
-0.3103
0.2903
-0.3077
0.2747
-0.1789
0.2459
Cash and
Equivalents
0.4144
0.4132
0.4062
0.3944
0.4267
0.3748
0.4397
0.3688
0.4221
0.3510
0.3784
0.3371
0.3146
0.3159
0.2600
0.2823
0.2327
0.2492
0.1896
0.2226
Dividend
0.0039
0.0195
0.0051
0.0091
0.0065
0.0089
0.0043
0.0106
0.0053
0.0111
0.0039
0.0115
0.0071
0.0127
0.0087
0.0146
0.0105
0.0180
0.0097
0.0202
Book Longterm Debt
0.1014
0.0850
0.1365
0.1074
0.1439
0.1286
0.1518
0.1412
0.1872
0.1558
0.2442
0.1745
0.3214
0.1944
0.3723
0.2177
0.3787
0.2274
0.3590
0.2271
Book Total
Debt
0.2276
0.1447
0.2508
0.1748
0.2463
0.1952
0.2370
0.2051
0.2702
0.2111
0.3198
0.2264
0.3939
0.2437
0.4357
0.2656
0.4394
0.2748
0.4179
0.2905
Market
Long-term
Debt
0.0521
0.0806
0.0872
0.1039
0.1021
0.1235
0.1162
0.1374
0.1468
0.1488
0.1915
0.1612
0.2471
0.1752
0.2898
0.1926
0.2920
0.2002
0.2878
0.2067
B. External Financing Activities
Size
Decile
1
1
2
2
3
3
4
4
5
5
6
6
7
7
8
8
9
9
10
10
Total
Retained
Earnings
-5.2296
0.3082
-1.7479
0.3014
-1.2568
0.2991
-0.8691
0.2892
-0.6213
0.2934
-0.5084
0.2899
-0.4025
0.2968
-0.3103
0.2903
-0.3077
0.2747
-0.1789
0.2459
Net Long-term
Debt Issue
0.0029
0.0004
0.0027
0.0020
-0.0039
0.0045
-0.0051
0.0050
-0.0049
0.0083
0.0039
0.0124
0.0160
0.0177
0.0196
0.0224
0.0356
0.0197
0.0209
0.0159
Net Total Debt
Issue
0.0008
-0.0041
0.0038
0.0012
-0.0008
0.0052
-0.0045
0.0065
-0.0033
0.0098
0.0029
0.0141
0.0168
0.0186
0.0185
0.0239
0.0344
0.0209
0.0172
0.0172
Net New
Equity Issue
0.3227
0.0348
0.1766
0.0353
0.1446
0.0348
0.1465
0.0370
0.1255
0.0330
0.1051
0.0259
0.0706
0.0170
0.0483
0.0092
0.0310
0.0047
0.0165
0.0003
Number of
Obs
12324
3989
9318
6891
7426
8575
6013
9764
4744
10931
3937
11657
3059
12270
2665
12551
2102
12897
1397
13324
155834
Market
Total Debt
0.1098
0.1370
0.1619
0.1684
0.1770
0.1877
0.1832
0.1998
0.2152
0.2023
0.2548
0.2109
0.3074
0.2213
0.3442
0.2354
0.3434
0.2415
0.3378
0.2612
Table V
Parameter Estimates from Cross-sectional/Panel Regressions on Determinants of Leverage Ratio
The sample consists of 146,553 firm-year observations with relevant Compustat data from 1971 to 2005. The dependent
variable is the total/long-term debt (TD/LD) divided by book/market value of assets (BA/MA). The independent variables
are as follows: dummy variable equal to one if the firm has negative retained earnings and zero otherwise (NegRet);
dummy variable equal to one if the firm has zero debt and zero otherwise (Zero); dummy variable equal to one for IPO
year and zero otherwise (IPO); cash and equivalents divided by total assets (Cash); industry median debt ratio (Med);
marginal tax rate equal to the statutory tax rate if the firm reports no net operating loss carryforwards with positive pretax
return and zero otherwise (Tax); operating Income divided by total assets (OI); market-to-book ratio of assets (MB); log of
book value of total assets (LnA); depreciation and amortization divided by total assets (DEP); fixed assets divided by total
assets (FA); research and development expenditures divided by total assets (RND); a dummy variable for missing values
in RND (D_RND); and common stock dividends divided by total assets (DIV). T-statistics p-values are in the parentheses.
Independent
Variable
Constant
LD / BA
0.0684
(0.0001)
0.2055
(0.0001)
0.2816
(0.0001)
-0.0527
(0.0001)
-0.0248
(0.0001)
-0.0119
(0.0001)
0.0155
(0.0001)
-0.2086
(0.0001)
0.2106
(0.0001)
-0.2185
(0.0001)
0.0095
(0.0001)
-2.2344
(0.0001)
0.1967
(0.0001)
-0.0599
(0.0001)
-0.1101
(0.0001)
-0.0017
(0.2081)
-0.1797
(0.0001)
0.2246
(0.0001)
-0.0062
(0.0075)
0.0318
(0.0001)
-0.0076
(0.0001)
0.0140
(0.0001)
-0.4138
(0.0001)
0.1348
(0.0001)
-0.0390
(0.0001)
0.0159
(0.0001)
-1.9337
(0.0001)
0.2595
0.3412
NegRet
Zero
IPO
Cash
Med
Tax
OI
MB
LnA
DEP
FA
RND
D_RND
DIV
Adjusted-R2
TD / BA
LD /MA
0.0956
(0.0001)
0.3232
(0.0001)
-0.0994
(0.0001)
-0.1068
(0.0001)
-0.0184
(0.0001)
0.0073
(0.0001)
-0.0395
(0.0264)
0.1792
(0.0001)
-0.4682
(0.0001)
0.0096
(0.0001)
-2.4436
(0.0001)
0.3904
(0.0001)
-0.0782
(0.0001)
-0.1790
(0.0001)
-0.0071
(0.0001)
-0.2575
(0.0001)
0.2405
(0.0001)
-0.0390
(0.0001)
-0.0298
(0.0001)
-0.0113
(0.0001)
0.0044
(0.0001)
-0.3319
(0.0001)
0.0665
(0.0001)
-0.1984
(0.0001)
0.0191
(0.0001)
-2.0101
(0.0001)
0.2288
0.3715
TD / MA
0.2272
(0.0001)
0.2803
(0.0001)
-0.0218
(0.0001)
-0.0359
(0.0001)
-0.0310
(0.0001)
0.0116
(0.0001)
-0.4373
(0.0001)
0.2069
(0.0001)
-0.1514
(0.0001)
0.0095
(0.0001)
-1.9972
(0.0001)
0.1840
(0.0001)
-0.0241
(0.0001)
-0.0750
(0.0001)
-0.0107
(0.0001)
-0.1354
(0.0001)
0.2411
(0.0001)
-0.0023
(0.2704)
-0.0084
(0.0008)
-0.0269
(0.0001)
0.0095
(0.0001)
-0.5609
(0.0001)
0.1475
(0.0001)
-0.0188
(0.0049)
0.0143
(0.0001)
-1.8326
(0.0001)
0.3221
(0.0001)
-0.0569
(0.0001)
-0.0834
(0.0001)
-0.0466
(0.0001)
0.0052
(0.0001)
-0.4252
(0.0001)
0.1812
(0.0001)
-0.3325
(0.0001)
0.0115
(0.0001)
-2.3792
(0.0001)
0.3544
(0.0001)
-0.0301
(0.0001)
-0.1232
(0.0001)
-0.0187
(0.0001)
-0.1925
(0.0001)
0.2653
(0.0001)
-0.0325
(0.0001)
-0.0461
(0.0001)
-0.0403
(0.0001)
0.0019
(0.0001)
-0.6026
(0.0001)
0.0939
(0.0001)
-0.1345
(0.0001)
0.0185
(0.0001)
-2.1390
(0.0001)
0.3483
0.3916
0.3494
0.4229
Table VI
Parameter Estimates from Cross-sectional/Panel Regressions on Determinants of Leverage Ratio Subsamples
Divided by Firm Size and Postive/Negative Retained Earnings
The sample consists of Compustat firms from 1971 to 2005. The dependent variable is the total/long-term debt (TD/LD)
divided by book/market value of assets (BA/MA). The independent variables are as follows: retained earnings over total
assets (Retained); dummy variable equal to one if the firm has zero debt and zero otherwise (Zero); dummy variable equal
to one for IPO year and zero otherwise (IPO); cash and equivalents divided by total assets (Cash); industry median debt
ratio (Med); marginal tax rate equal to the statutory tax rate if the firm reports no net operating loss carryforwards with
positive pretax return and zero otherwise (Tax); operating Income divided by total assets (OI); market-to-book ratio of
assets (MB); log of book value of total assets (LnA); depreciation and amortization divided by total assets (DEP); fixed
assets divided by total assets (FA); research and development expenditures divided by total assets (RND); a dummy
variable for missing values in RND (D_RND); and common stock dividends divided by total assets (DIV). T-statistics pvalues are in the parentheses.
A. Small Firms with Positive Retained Earnings (Large = 0; posret = 1) (Obs = 35494)
Independent
Variable
Constant
LD / BA
0.0639
(0.0001)
0.2076
(0.0001)
0.1210
(0.0001)
0.0095
(0.0075)
-0.0207
(0.0072)
-0.0167
(0.0001)
0.0132
(0.0001)
-0.6190
(0.0001)
0.3011
(0.0001)
-0.2564
(0.0001)
-0.0024
(0.1009)
-1.8208
(0.0001)
0.1805
(0.0001)
-0.2159
(0.0001)
-0.0760
(0.0001)
-0.0137
(0.0001)
-0.1197
(0.0001)
0.0690
(0.0001)
0.0399
(0.0001)
0.0405
(0.0001)
-0.0139
(0.0001)
0.0116
(0.0001)
-0.5234
(0.0001)
0.2059
(0.0001)
-0.1022
(0.0001)
0.0018
(0.1784)
-0.5368
(0.0001)
0.2619
0.3992
Retained
Zero
IPO
Cash
Med
Tax
OI
MB
LnA
DEP
FA
RND
D_RND
DIV
Adjusted-R2
TD / BA
LD /MA
0.0850
(0.0001)
0.1855
(0.0001)
-0.0337
(0.0001)
-0.0948
(0.0001)
-0.0242
(0.0001)
0.0040
(0.0001)
-0.7032
(0.0001)
0.2641
(0.0001)
-0.5093
(0.0001)
0.0005
(0.7769)
-2.6551
(0.0001)
0.3939
(0.0001)
-0.3101
(0.0001)
-0.1270
(0.0001)
-0.0178
(0.0001)
-0.2076
(0.0001)
0.1007
(0.0001)
0.0095
(0.0113)
-0.0070
(0.3860)
-0.0185
(0.0001)
0.0013
(0.0859)
-0.5489
(0.0001)
0.1047
(0.0001)
-0.2502
(0.0001)
0.0084
(0.0001)
-0.7151
(0.0001)
0.2370
0.4635
TD / MA
0.2349
(0.0001)
0.1582
(0.0001)
0.0225
(0.0001)
-0.0861
(0.0001)
-0.0339
(0.0001)
0.0150
(0.0001)
-0.5646
(0.0001)
0.2716
(0.0001)
-0.2618
(0.0001)
-0.0028
(0.0616)
-1.7131
(0.0001)
0.1896
(0.0001)
-0.1779
(0.0001)
-0.0638
(0.0001)
-0.0212
(0.0001)
-0.1118
(0.0001)
0.1136
(0.0001)
0.0487
(0.0001)
-0.0350
(0.0001)
-0.0306
(0.0001)
0.0130
(0.0001)
-0.4934
(0.0001)
0.1867
(0.0001)
-0.1287
(0.0001)
0.0015
(0.2796)
-0.6541
(0.0001)
0.2351
(0.0001)
-0.0157
(0.0004)
-0.1905
(0.0001)
-0.0508
(0.0001)
0.0081
(0.0001)
-0.6532
(0.0001)
0.2302
(0.0001)
-0.5144
(0.0001)
0.0008
(0.6852)
-2.4987
(0.0001)
0.4052
(0.0001)
-0.2526
(0.0001)
-0.1073
(0.0001)
-0.0303
(0.0001)
-0.2002
(0.0001)
0.1608
(0.0001)
0.0212
(0.0001)
-0.1179
(0.0001)
-0.0442
(0.0001)
0.0046
(0.0001)
-0.5365
(0.0001)
0.0847
(0.0001)
-0.2863
(0.0001)
0.0089
(0.0001)
-0.9023
(0.0001)
0.3048
0.3960
0.3161
0.4602
B. Small Firms with Negative Retained Earnings (Large = 0; posret = 0) (Obs = 31550)
Independent
Variable
Constant
LD / BA
0.0690
(0.0001)
0.2211
(0.0001)
0.1838
(0.0001)
0.0072
(0.5932)
0.0399
(0.0001)
-0.0058
(0.0001)
0.0075
(0.0001)
-0.0270
(0.3101)
0.2320
(0.0001)
-0.1222
(0.0001)
0.0093
(0.0001)
-0.1726
(0.2635)
0.1541
(0.0001)
-0.0054
(0.0001)
-0.1025
(0.0001)
-0.0066
(0.0150)
-0.1582
(0.0001)
0.1322
(0.0001)
0.0164
(0.2014)
0.0498
(0.0001)
-0.0021
(0.0001)
0.0110
(0.0001)
-0.2348
(0.0001)
0.1467
(0.0001)
-0.0032
(0.7796)
0.0112
(0.0001)
-0.1343
(0.3608)
0.1555
0.2350
Retained
Zero
IPO
Cash
Med
Tax
OI
MB
LnA
DEP
FA
RND
D_RND
DIV
Adjusted-R2
TD / BA
LD /MA
0.0679
(0.0001)
0.2584
(0.0001)
-0.0730
(0.0001)
0.0019
(0.7298)
-0.0135
(0.0001)
-0.0081
(0.0001)
0.3195
(0.0001)
0.2174
(0.0001)
-0.3443
(0.0001)
0.0235
(0.0001)
-0.6657
(0.0007)
0.3763
(0.0001)
-0.0039
(0.0001)
-0.1929
(0.0001)
-0.0208
(0.0001)
-0.2705
(0.0001)
0.1674
(0.0001)
-0.0592
(0.0001)
0.0077
(0.1329)
-0.0063
(0.0001)
-0.0030
(0.0023)
-0.0171
(0.5882)
0.0644
(0.0001)
-0.1239
(0.0001)
0.0270
(0.0001)
-0.5842
(0.0010)
0.1791
0.3340
TD / MA
0.1884
(0.0001)
0.1476
(0.0001)
0.0091
(0.3538)
0.0425
(0.0001)
-0.0163
(0.0001)
0.0092
(0.0001)
-0.1033
(0.0001)
0.1658
(0.0001)
-0.0924
(0.0001)
0.0104
(0.0001)
-0.4323
(0.0001)
0.1299
(0.0001)
-0.0001
(0.8748)
-0.0588
(0.0001)
-0.0120
(0.0001)
-0.1094
(0.0001)
0.1149
(0.0001)
0.0144
(0.1300)
0.0425
(0.0001)
-0.0135
(0.0001)
0.0107
(0.0001)
-0.2199
(0.0001)
0.1060
(0.0001)
-0.0080
(0.3492)
0.0120
(0.0001)
-0.3884
(0.0004)
0.1968
(0.0001)
-0.0526
(0.0001)
0.0318
(0.0001)
-0.0316
(0.0001)
0.0033
(0.0001)
0.0456
(0.0686)
0.1581
(0.0001)
-0.2395
(0.0001)
0.0226
(0.0001)
-1.0917
(0.0001)
0.3001
(0.0001)
0.0040
(0.0001)
-0.1129
(0.0001)
-0.0283
(0.0001)
-0.1836
(0.0001)
0.1396
(0.0001)
-0.0450
(0.0001)
0.0232
(0.0001)
-0.0261
(0.0001)
0.0050
(0.0001)
-0.1372
(0.0001)
0.0522
(0.0001)
-0.0846
(0.0001)
0.0254
(0.0001)
-1.0052
(0.0001)
0.2375
0.2901
0.2985
0.3955
C. Large Firms with Positive Retained Earnings (Large = 1; posret = 1) (Obs = 54508)
Independent
Variable
Constant
LD / BA
0.1719
(0.0001)
0.2606
(0.0001)
0.2559
(0.0001)
-0.0325
(0.0001)
-0.1188
(0.0001)
-0.0196
(0.0001)
0.0055
(0.0001)
-0.5648
(0.0001)
0.2011
(0.0001)
-0.4746
(0.0001)
0.0044
(0.0005)
-2.0472
(0.0001)
0.3395
(0.0001)
-0.3032
(0.0001)
-0.0974
(0.0001)
-0.0183
(0.0001)
-0.1989
(0.0001)
0.1459
(0.0001)
0.0183
(0.0001)
0.0336
(0.0001)
-0.0109
(0.0001)
-0.0009
(0.0080)
-0.4208
(0.0001)
0.0998
(0.0001)
-0.1979
(0.0001)
0.0038
(0.0007)
-0.8934
(0.0001)
0.3192
0.4639
Retained
Zero
IPO
Cash
Med
Tax
OI
MB
LnA
DEP
FA
RND
D_RND
DIV
Adjusted-R2
TD / BA
LD /MA
0.2292
(0.0001)
0.2970
(0.0001)
-0.0356
(0.0001)
-0.2254
(0.0001)
-0.0253
(0.0001)
0.0048
(0.0001)
-0.6547
(0.0001)
0.1670
(0.0001)
-0.5593
(0.0001)
0.0026
(0.0620)
-1.9990
(0.0001)
0.4496
(0.0001)
-0.3525
(0.0001)
-0.1358
(0.0001)
-0.0106
(0.0001)
-0.2183
(0.0001)
0.1709
(0.0001)
0.0221
(0.0001)
-0.0464
(0.0001)
-0.0148
(0.0001)
-0.0026
(0.0001)
-0.4863
(0.0001)
0.0520
(0.0001)
-0.2348
(0.0001)
0.0018
(0.1304)
-0.6575
(0.0001)
0.3075
0.4833
TD / MA
0.3363
(0.0001)
0.2692
(0.0001)
-0.0178
(0.0001)
-0.2435
(0.0001)
-0.0426
(0.0001)
-0.0012
(0.0013)
-0.7573
(0.0001)
0.2205
(0.0001)
-0.2406
(0.0001)
0.0073
(0.0001)
-1.7345
(0.0001)
0.3623
(0.0001)
-0.2562
(0.0001)
-0.0525
(0.0001)
-0.0297
(0.0001)
-0.1505
(0.0001)
0.1801
(0.0001)
0.0259
(0.0001)
-0.1156
(0.0001)
-0.0366
(0.0001)
-0.0062
(0.0001)
-0.6385
(0.0001)
0.1433
(0.0001)
-0.0436
(0.0095)
0.0059
(0.0001)
-0.7702
(0.0001)
0.3181
(0.0001)
-0.0178
(0.0001)
-0.3822
(0.0001)
-0.0539
(0.0001)
-0.0040
(0.0001)
-0.8692
(0.0001)
0.1935
(0.0001)
-0.3130
(0.0001)
0.0062
(0.0001)
-1.8094
(0.0001)
0.4878
(0.0001)
-0.2985
(0.0001)
-0.0780
(0.0001)
-0.0274
(0.0001)
-0.1670
(0.0001)
0.2154
(0.0001)
0.0322
(0.0001)
-0.2320
(0.0001)
-0.0465
(0.0001)
-0.0098
(0.0001)
-0.7302
(0.0001)
0.1053
(0.0001)
-0.0805
(0.0001)
0.0045
(0.0002)
-0.6858
(0.0001)
0.4286
0.5126
0.4385
0.5312
D. Large Firms with Negative Retained Earnings (Large = 1; posret = 0) (Obs = 11218)
Independent
Variable
Constant
LD / BA
0.1334
(0.0001)
0.2916
(0.0001)
0.5824
(0.0001)
0.0026
(0.9151)
0.2531
(0.0001)
-0.0094
(0.0001)
0.0092
(0.0001)
-0.0463
(0.4703)
0.1438
(0.0001)
-0.2450
(0.0001)
0.0235
(0.0001)
-1.3241
(0.0001)
0.2762
(0.0001)
-0.0169
(0.0001)
-0.2242
(0.0001)
-0.0214
(0.0013)
-0.2437
(0.0001)
0.4681
(0.0001)
0.0116
(0.6214)
0.2028
(0.0001)
0.0022
(0.2338)
0.0028
(0.0817)
-0.1912
(0.0024)
0.0724
(0.0001)
-0.0309
(0.4336)
0.0231
(0.0001)
-1.3598
(0.0001)
0.1963
0.2644
Retained
Zero
IPO
Cash
Med
Tax
OI
MB
LnA
DEP
FA
RND
D_RND
DIV
Adjusted-R2
TD / BA
LD /MA
0.2018
(0.0001)
0.6110
(0.0001)
-0.0148
(0.5532)
0.1803
(0.0001)
-0.0194
(0.0001)
-0.0033
(0.0539)
-0.0054
(0.9337)
0.1584
(0.0001)
-0.4524
(0.0001)
0.0197
(0.0001)
-1.1891
(0.0001)
0.4642
(0.0001)
-0.0195
(0.0001)
-0.2780
(0.0001)
-0.0455
(0.0001)
-0.2840
(0.0001)
0.4771
(0.0001)
-0.0002
(0.9926)
0.1173
(0.0001)
-0.0048
(0.0092)
-0.0113
(0.0001)
-0.1775
(0.0045)
0.0730
(0.0001)
-0.2108
(0.0001)
0.0191
(0.0001)
-1.2291
(0.0001)
0.2243
0.3201
TD / MA
0.3453
(0.0001)
0.4289
(0.0001)
-0.0452
(0.0181)
0.1614
(0.0001)
-0.0472
(0.0001)
0.0039
(0.0030)
-0.2271
(0.0001)
0.1527
(0.0001)
-0.2313
(0.0001)
0.0071
(0.0712)
-1.5774
(0.0001)
0.3179
(0.0001)
0.0081
(0.0016)
-0.1355
(0.0001)
-0.0251
(0.0001)
-0.1984
(0.0001)
0.3440
(0.0001)
-0.0385
(0.0379)
0.0980
(0.0001)
-0.0371
(0.0001)
-0.0011
(0.3836)
-0.2665
(0.0001)
0.0921
(0.0001)
-0.0461
(0.1376)
0.0074
(0.0499)
-1.5930
(0.0001)
0.4485
(0.0001)
-0.0674
(0.0006)
0.0913
(0.0001)
-0.0615
(0.0001)
-0.0065
(0.0001)
-0.2403
(0.0001)
0.1701
(0.0001)
-0.4071
(0.0001)
0.0051
(0.2111)
-1.6544
(0.0001)
0.4864
(0.0001)
0.0105
(0.0001)
-0.1744
(0.0001)
-0.0472
(0.0001)
-0.2313
(0.0001)
0.3485
(0.0001)
-0.0560
(0.0028)
0.0124
(0.4115)
-0.0486
(0.0001)
-0.0128
(0.0001)
-0.2855
(0.0001)
0.0973
(0.0001)
-0.1967
(0.0001)
0.0053
(0.1697)
-1.6728
(0.0001)
0.3040
0.3507
0.3620
0.4253