HOW SENSITIVE ARE JAPANESE FIRMS TO EARNINGS VOLATILITY? EVIDENCE FROM CASH HOLDINGS

Abstract We investigate the hypothesis that cash balances have a precautionary motive and serve to mitigate the volatility of operating earnings, which we use as a proxy for risk. Our results show that cash holdings are positively associated with firm level risk, but negatively related to industry risk. Consistent with previous findings, cash holdings are decreasing with the firm's size and debt ratio, and increasing with its profitability, growth prospects, and dividend payout ratio. The precautionary motive for holding cash is investigated by undertaking various classification schemes under which cash shortages have different funding cost implications. We find that Keiretsu affiliated firms hold less cash and are less risk sensitive. Firms with diffused ownership are more sensitive to potential earnings shortfalls. There is evidence that financial constraints reduce the incentives to mitigate earnings risk. Finally, we show that bank-controlled firms and highly leveraged firms increased their sensitivity to earnings volatility as the condition of Japanese banks deteriorated after 1998. Overall, our results strongly support the precautionary motive for holding cash and emphasize the importance of risk mitigation