Covenant Violations and Corporate Liquidity Management

I study the impact of loan covenant violations on corporate liquidity management. Specif-ically, I find that firms exhibit a strong tendency to save cash out of their cash flows after covenant violations (as represented by a positive and greater cash flow sensitivity of cash), sug-gesting that firms turn to internally-generated cash for liquidity after breaching external credit contracts. Moreover, the increase in the cash saving rate after covenant violations is more pronounced among firms that are likely to be financially constrained, firms that have greater hedging needs, and firms that depend more on external finance. These findings are consistent with the argument that covenant violations lead to a tightening of external credit, which then causes firms to rely more on self-produced cash for liquidity. Additional tests suggest that this effect is not driven by other alternative explanations or selection bias. Collectively, the empirical evidence supports a predicted relationship between a firm's external financing condition and its internal liquidity management policy