Employment stability and corporate cash holdings

This paper investigates how a firm's employment stability affects the level of its cash holdings. We find that firms with high employment stability (as measured by one minus a firm's employment elasticity with respect to its sales) maintain large cash holdings. The positive effect of employment stability on cash holdings is stronger for R&D intensive firms and firms with high firm-specific human capital. These results are consistent with theories predicting that firms hold cash to signal the credibility of their employment policies regarding job security.

Keywords: Cash holdings; employment stability; job security; implicit contract

I. Introduction

Theoretical research on corporate finance emphasizes that job security is critical in motivating employees to invest in innovative activities (Manso [12]) and make firm-specific investments (Jaggia and Thakor [7]). In exchange for the risk associated with innovative projects and employees' market value that is sacrificed due to the firm-specificity of investments, firms should offer a high level of job security, which is generally promised in the form of implicit contracts (Akerlof and Miyazaki [2]). However, these implicit contracts have weak legal standing given that the United States has adopted an employment-at-will doctrine. Then, if a firm becomes financially distressed, it is likely to breach the implicit contracts related to job security and terminate employees to avoid immediate bankruptcy. If employees recognize the possibility of breaching those implicit contracts, they will reduce investments in innovation and firm-specific human capital. Therefore, the stakeholder theory of corporate financial policy suggests that firms that offer a high level of job security should adopt a conservative financial policy to signal their commitment to implicit contracts with their employees (Maksimovic and Titman [11]). In this paper, we examine whether a firm's cash holdings complement its employment policies regarding job security by enhancing the credibility of the policies.

Using a sample of 90,753 firm-year observations from 1970 to 2012, we examine the relation between a firm's level of job security and its cash holdings. We measure the degree of job security by estimating firm-level employment stability, defined as one minus a firm's employment elasticity with respect to its sales (Han and Kim [5]) based on the dynamic labour demand theory suggesting that firing frictions reduce employment adjustment to economic fluctuations (Adhvaryu, Chari, and Sharma [1]). We find that firms with high employment stability have large cash holdings, controlling for state-by-year, firm fixed effects, and time-varying firm characteristics. This result is consistent with the stakeholder theory predicting that firms hold cash to reassure their employees that they can credibly keep their stable employment policies.

An important implication of stakeholder theory is that the positive relation between employment stability and cash holdings should be more pronounced for firms that have stronger incentives to maintain their job security reputation (Maksimovic and Titman [11]). We find that the effect of employment stability on cash holdings is stronger for R&D intensive firms, which have greater incentives to retain employees since employees are willing to innovate when they are less likely to be fired for early failure and more likely to capture a fair share of the surplus resulting from innovation (Manso [12]). In addition, we find that the positive association between employment stability and cash holdings is more salient for firms with higher firm-specific knowledge (as measured by the share of patent citations that cite a firm's previous patents), which have stronger incentives to adopt stable employment policies since without job security, employees are not willing to make firm-specific investments that generate lower exchange value in the external labour market (Jaggia and Thakor [7]).

Our paper contributes to a growing body of literature on how labour-related factors affect corporate cash holdings. Prior research documents that strategic bargaining with labour unions (Klasa, Maxwell, and Ortiz-Molina [9]), employee treatment (Ghaly, Dang, and Stathopoulos [4]), unemployment risk (Devos and Rahman [3]), and talent competition (He [6]) have significant influences on corporate cash holding decisions. This study adds to the literature by identifying a complementary role of a firm's cash holdings to its stable employment policies by increasing the credibility of the policies.

Our study is also related to the literature on employment instability, the degree to which a firm adjusts the size of its workforce. This literature measures a firm's employment instability by the volatility of its employment levels (Ji, Guthrie, and Messersmith [8]). However, this employment instability measure is determined by not only a firm's employment decisions but also the volatility of business environment. This paper better captures employment instability/stability by estimating the sensitivity of employment in responding to labour demand changes in order to disentangle a firm's employment policy from business volatility.

II. Data and summary statistics

Sample

Our sample consists of all publicly traded non-financial and non-utility US firms in Compustat North America from 1970 to 2012. We obtain patent data that are used for a cross-sectional study from Noah Stoffman's website (Kogan et al. [10]), which lists patents awarded by the United States Patent and Trademark Office (USPTO). After removing observations with missing values, our main sample includes 90,753 firm-year observations.

Employment stability

A key implication of dynamic labour demand models is that firing restrictions attenuate a firm's employment adjustment to economic fluctuations (Adhvaryu, Chari, and Sharma [1]). When firms limit layoffs during a downturn, hiring during upturns is also restricted to prevent layoffs in future downturns. Based on the theory just described, we assess a firm's level of job security by estimating the elasticity of its employment to its sales (Han and Kim [5]). Specifically, we first compute the regression coefficient of a firm's employment growth rate on its sales growth rate using the past five-year observations. Then, we measure employment stability by subtracting the regression coefficient from one to indicate the distance from unit elasticity. Firms with high employment stability make slow employment adjustments to labour demand changes. We conduct a validity check for our employment stability measure. The (untabulated) findings show that firms whose headquarters are in the states that adopt wrongful discharge laws which are deemed to have better employment protection legislation exhibit higher levels of employment stability.

Summary statistics

Table 1 reports the summary statistics for the variables used in our study. On average, a firm changes its employment by 0.72% in response to 1% change in sales. An average firm in our sample has cash holdings of 16%, cash flow of −1%, net working capital of 8%, capital expenditures of 6%, leverage of 26%, acquisitions of 2%, Tobin's q of 1.91, size of 4.76, industry cash flow volatility of 13%, and R&D expenditures of 5%. Firms that account for 34% of observations pay dividends. The average share of patent citations that cite a firm's previous patents is 7%. The appendix provides a detailed description of the variables.

Table 1. Summary statistics

Variable	Mean	Std. Dev.	P25	Median	P75
Dependent variable
Cash holdings	0.16	0.19	0.02	0.08	0.22
Independent variable
Employment stability	0.28	0.59	0.04	0.40	0.69
Control variable
Cash flow	−0.01	0.33	0.00	0.07	0.12
Net working capital	0.08	0.31	−0.02	0.11	0.25
Capital expenditures	0.06	0.06	0.02	0.04	0.08
Leverage	0.26	0.27	0.05	0.21	0.37
Acquisitions	0.02	0.08	0.00	0.00	0.00
Tobin's q	1.91	1.87	1.02	1.34	2.00
Size	4.76	2.19	3.18	4.69	6.27
Industry cash flow volatility	0.13	0.06	0.07	0.13	0.15
R&D expenditures	0.05	0.11	0.00	0.00	0.05
Dividend payout	0.34	0.48	0.00	0.00	1.00
Other firm characteristics
Firm-specific knowledge	0.07	0.11	0.00	0.04	0.11

1 N = 90,753. For firm-specific knowledge, N = 22,827.

III. Empirical results

Model 1 in Table 2 presents the regression results for the relation between employment stability and cash holdings. We include the determinants of cash holdings as control variables following previous literature on corporate cash holdings (Ghaly, Dang, and Stathopoulos [4]). We also include state-by-year fixed effects to rule out alternative explanations that our findings might be driven by heterogeneity in state labour laws such as right-to-work laws (Klasa, Maxwell, and Ortiz-Molina [9]), wrongful discharge laws (Ghaly, Dang, and Stathopoulos [4]), and unemployment insurance benefit laws (Devos and Rahman [3]), and firm fixed effects to control for time-invariant omitted firm characteristics. The estimated coefficient on employment stability is positive and statistically significant at the 1% level. An increase by one standard deviation of 0.59 in employment stability is associated with an increase in cash holdings by 0.18 (= 0.003 ×0.59 × 100) percentage points. The result supports the hypothesis that firms with high employment stability have large cash holdings to signal their commitment to stable employment policies.

Table 2. Regression analyses for cash holdings

	Cash holdings
Variable	(1)	(2)	(3)
Employment stability	0.003***	−0.000	0.005**
	(2.95)	(−0.44)	(2.18)
Employment stability × High R&D intensity		0.008***
		(4.04)
Employment stability × High firm-specific knowledge			0.006**
			(2.10)
High R&D intensity		0.006*
		(1.69)
High firm-specific knowledge			−0.001
			(−0.40)
Cash flow	0.020***	0.020***	0.041***
	(4.93)	(4.90)	(3.96)
Net working capital	−0.111***	−0.112***	−0.267***
	(−20.88)	(−21.02)	(−15.49)
Capital expenditures	−0.277***	−0.277***	−0.410***
	(−22.53)	(−22.52)	(−14.97)
Leverage	−0.191***	−0.190***	−0.202***
	(−34.29)	(−34.26)	(−17.13)
Acquisitions	−0.111***	−0.111***	−0.147***
	(−17.59)	(−17.57)	(−10.46)
Tobin's q	0.009***	0.009***	0.009***
	(13.43)	(13.42)	(7.45)
Size	−0.003**	−0.004**	−0.006**
	(−2.32)	(−2.46)	(−1.98)
Industry cash flow volatility	0.120**	0.117**	−0.121*
	(2.41)	(2.36)	(−1.85)
R&D expenditures	−0.104***	−0.110***	−0.183***
	(−5.88)	(−6.17)	(−5.99)
Dividend payout	0.007***	0.007***	−0.000
	(3.02)	(3.06)	(−0.08)
State × year fixed effects	Yes	Yes	Yes
Firm fixed effects	Yes	Yes	Yes
Observations	89,656	89,656	21,603
Adjusted R2	0.71	0.71	0.81

2 Standard errors are clustered at the firm level, and the t-statistics are reported in parentheses. *, **, *** indicate significance at the 10%, 5%, and 1% level, respectively.

We next exploit cross-sectional variation in the firm characteristics to provide support for the underlying hypothesized mechanisms. First, we define firms with positive (zero) R&D expenditures as having high (low) R&D intensity. Model 2 in Table 2 shows that employment stability has little to no effect on the cash holdings of firms with low R&D intensity. For firms with high R&D intensity, however, we find a positive and statistically significant relation between employment stability and cash holdings. This result supports the prediction that R&D intensive firms have stronger incentives to hold cash in order to maintain a reputation for employment stability. Next, we define firms with above-median (below-median) values for self-citing patents as relying on high (low) firm-specific knowledge. Model 3 in Table 2 shows that the coefficient on employment stability for firms with high firm-specific knowledge (0.011) is more than twice that of firms with low firm-specific knowledge (0.005). The difference between the two coefficients is statistically significant at the 5% level. This finding is consistent with the hypothesis that firms with high firm-specific human capital are more willing to reassure employees about the credibility of their stable employment policies by holding cash.

For robustness checks, we use alternative measurements for cash holdings including the ratio of cash to net assets (where net assets equal total assets minus cash), the natural log of the ratio of cash to net assets, and the ratio of cash to sales (Ghaly, Dang, and Stathopoulos [4]). Our results are robust to these variables. In addition, we perform a two-stage least squares (2SLS) regression analysis to address potential endogeneity problems caused by omitted variables or reverse causality. We use industry-level employment stability (the average of firm-level employment stability in the same two-digit SIC industry and year after removing the focal firm) as an instrumental variable. Using the industry-level employment stability reduces the concern that the instrumental variable is affected by unobservable firm characteristics that are also related to cash holdings. Moreover, a firm's cash holdings are unlikely to affect the industry-level employment stability. The (untabulated) results of instrumental variable regressions confirm that employment stability has a positive and statistically significant effect on cash holdings.

IV. Conclusion

We investigate how a firm's employment policy affects its financial policy. We find a positive relation between employment stability and cash holdings. Furthermore, we find this positive relation is stronger for R&D intensive firms and firms with high firm-specific human capital, which have greater incentives to maintain their reputation for employment stability. These findings are consistent with the stakeholder theory of financial policy suggesting that firms use cash holdings to show employees that they can credibly maintain their stable employment policies.

Disclosure statement

No potential conflict of interest was reported by the authors.

Appendix A

Table A1. Description of variables

Variable	Description
Cash holdings	Cash (che) over total assets (at).
Employment stability	One minus the regression coefficient of a firm's employment (emp) growth rate on its sales (sale) growth rate using the past five-year observations.
Cash flow	Income before extraordinary items (ib) plus depreciation (dp) over total assets (at).
Net working capital	Working capital (wcap) minus cash (che) over total assets (at).
Capital expenditures	Capital expenditures (capx) over total assets (at).
Leverage	Debt in current liabilities (dlc) plus long-term debt (dltt) over total assets (at).
Acquisitions	Acquisitions (aqc) over sales (sale).
Tobin's q	The book value of assets (at) minus the book value of common equity (ceq) plus the market value of common equity (prcc_f × csho) over the book value of assets (at).
Size	The natural log of total assets (at).
Industry cash flow volatility	The average standard deviation of cash flow over the past five years in each industry defined by two-digit SIC codes.
R&D expenditures	Research and development expenses (xrd) over total assets (at).
Acquisitions	Acquisitions (aqc) over sales (sale).
Dividend payout	An indicator variable set to one if a firm pays a common dividend (dvc) during a fiscal year and zero otherwise.
Firm-specific knowledge	The number of patent citations that cite a firm's previous patents over the total number of patent citations

3 Note. Variable definitions in parentheses refer to Compustat designations where appropriate.

1 Adhvaryu, A., A. V. Chari, and S. Sharma. 2013. " Firing Costs and Flexibility: Evidence from Firms' Employment Responses to Shocks in India." The Review of Economics and Statistics 95 (3): 725 – 740. doi: 10.1162/REST_a_00305. 2 Akerlof, G. A., and H. Miyazaki. 1980. " The Implicit Contract Theory of Unemployment Meets the Wage Bill Argument." The Review of Economic Studies 47 (2): 321 – 338. doi: 10.2307/2296995. 3 Devos, E., and S. Rahman. 2018. " Labor Unemployment Insurance and Firm Cash Holdings." Journal of Corporate Finance 49 : 15 – 31. doi: 10.1016/j.jcorpfin.2017.12.019. 4 Ghaly, M., V. A. Dang, and K. Stathopoulos. 2015. " Cash Holdings and Employee Welfare." Journal of Corporate Finance 33 : 53 – 70. doi: 10.1016/j.jcorpfin.2015.04.003. 5 Han, S., and C. Kim. 2020. " Employment Stability and Corporate Innovation." Applied Economics Letters 27 (21): 1722 – 1725. doi: 10.1080/13504851.2020.1716936. 6 He, Z. 2018. " Money Held for Moving Stars: Talent Competition and Corporate Cash Holdings." Journal of Corporate Finance 51 : 210 – 234. doi: 10.1016/j.jcorpfin.2018.06.002. 7 Jaggia, P. B., and A. V. Thakor. 1994. " Firm-specific Human Capital and Optimal Capital Structure." International Economic Review 35 (2): 283 – 308. doi: 10.2307/2527054. 8 Ji, Y. Y., J. P. Guthrie, and J. G. Messersmith. 2014. " The Tortoise and the Hare: The Impact of Employment Instability on Firm Performance." Human Resource Management Journal 24 : 355 – 373. doi: 10.1111/1748-8583.12052. 9 Klasa, S., W. F. Maxwell, and H. Ortiz-Molina. 2009. " The Strategic Use of Corporate Cash Holdings in Collective Bargaining with Labor Unions." Journal of Financial Economics 92 (3): 421 – 442. doi: 10.1016/j.jfineco.2008.07.003. Kogan, L., D. Papanikolaou, A. Seru, and N. Stoffman. 2017. " Technological Innovation." Resource Allocation, and Growth. The Quarterly Journal of Economics 132 (2): 665 – 712. Maksimovic, V., and S. Titman. 1991. " Financial Policy and Reputation for Product Quality." The Review of Financial Studies 4 (1): 175 – 200. doi: 10.1093/rfs/4.1.175. Manso, G. 2011. " Motivating Innovation." The Journal of Finance 66 (5): 1823 – 1860. doi: 10.1111/j.1540-6261.2011.01688.x.

By Syungjin Han and Changhyun Kim

Reported by Author; Author