Liquidity Crisis and Cash-Based Real Activity Management

In this paper, I investigate the association between a liquidity crisis and cash-based real activity management. Specifically, I hypothesize that a liquidity crisis creates incentives for firms to engage in cash-saving and cash-generating activities. I define liquidity crises as a situation in which a firm experiences consecutive cash shortages in the prior three years. The concept as applied to this study differs from financial distress. First, unlike financial distress that often foreshadows failure or bankruptcy (e.g., Wruck 1990), it refers to operational problem over which firms have considerable discretion over the appropriate actions to take; furthermore the actions they take do not require contract re-negotiations or intervention by external stakeholders as noted by Wruck (1990). The importance of liquidity to investors is also highlighted by the U.S. Securities and Exchange Commission (SEC). In particular, the SEC requires companies to discuss their liquidity positions in the Management's Discussion and Analysis section of their annual reports and to disclose the steps or plans they take to remedy any material deficiencies in their short- or long-term liquidity. Several anecdotes and the SEC's focus on the liquidity disclosures suggest that firms would manage their liquidity positions as part of their corporate strategies. In this study, I propose and test that firms with deteriorating liquidity have an incentive to re-optimize their liquidity positions not only to ease the operational or financing constraints but also to shore up investor confidence. To the extent that firms respond to liquidity crises via cash-based real activity management, I observe a positive association between my measures of cash-based real activities and liquidity crises. Specifically, the results show that firms with liquidity crises would engage in various cash-based real activities, including asset sales, plant (store) closings, dividend cuts (omissions), reduction in discretionary expenses and abnormal productions. I further test the impact of these actions on the one-year and three-year ahead stock returns and find that investors appear to not respond to the various cash-based real activities during the one-year and three-year period following such activities. This study sheds light on the real activity management literature by providing evidence that a liquidity or cash crisis is a driver of cash-based real activity management.