Capital structure, firm liquidity and growth

This paper is an exploration of the relationships among the firm's financial structure, its choice of liquid asset holdings, and growth. We present a theoretical model of the firm where external finance is costly and where retaining earnings as liquid assets serves a precautionary motive. One of the predictions of this model is that a long-term reliance on high levels of debt finance tends to be associated with high levels of liquid asset holding. We test this empirically by estimating the determinants of liquid asset holdings using panel data sets of Belgian and UK firms. We find evidence of a positive relation between leverage and liquid asset holding. This result leads us to identify a possible linkage from high debt to high liquidity to slow growth. In light of this we discuss the possible implications of the development of stock markets, private equity, and venture capital markets.