ACCOUNTING MEASURES OF CORPORATE LIQUIDITY, LEVERAGE, AND COSTS OF FINANCIAL DISTRESS

A general view of financial distress is that it results from a mismatch between the currently available liquid assets of a firm and its current obligations under its ''hard'' financial contracts. Mechanisms for dealing with financial distress rectify the mismatch by either restructuring the assets or restructuring the financing contracts, or both. The costs of financial distress are those resulting from the costs of asset restructuring (converting illiquid assets to liquid ones) or the costs of informal or formal debt restructuring. The costs of financial distress will have important implications for the liquidity and leverage policies of a firm. In particular, when the costs of financial distress are high, the firm may maintain a larger fraction of its assets as liquid assets and/or be cautious in taking on debt (hard contracts). In this study, I analyze the relationship between the costs of financial distress and (i) the corporate liquidity policy, and (ii) the leverage policy of a firm. Liquid assets constitute a considerable portion of total assets and have important implications for the firm's risk and profitability. For instance, Baskin [6] reports that among his sample of 338 major U.S. corporations, 9.6% of invested capital was held ir cash and marketable securities in 1972. In our sample of 223 major U.S. corporations, the average annual liquidity ratio was 6.3% in the period 1979-198 1. Kallberg [ 19] documents that top managers pay a lot of attention to management of corporate liquidity. In his book on liquidity management, Kallberg [19] provides six stages of decreasing liquidity as follows: (i) meeting cun-ent obligations from current cash flows, cash balances and short-term investments; (ii) using short-term credit; (iii) careful management of cash flows, e.g., through management of credit policy and inventory levels; (iv) renegotiation of debt contracts; (v) asset sales; and (vi) bankruptcy. This scheme suggests a direct link between liquidity policies pursued by management and costs of financial distress. Using various proxies for the different direct and indirect costs at various stages of financial distress, its relationship to corporate liquidity is examined. Although several measures of corporate liquidity have been suggested, I focus on the accounting measures of liquidity, such as the liquid ratio. A second response to high financial distress costs is to limit the use of debt financing. Although the inverse relationship between bankruptcy costs and leverage has been studied previously, I will propose new measures of asset illiquidity and indirect bankruptcy costs in exploring the relationship between leverage and the costs of financial distress.1 The remainder of the paper is organized as follows. In Section I, a simple model of dealing with financial distress is used to develop testable relationships between (i) distress costs and corporate liquidity policy, and (ii) distress costs and corporate leverage. Several proxies for different components of financial distress are developed in Section I.C. Methodology and data are described in Section II. Results are presented in Section III. Section IV concludes.