Causes and consequences of Cash Flow Sensitivity: Empirical Tests of the US Lodging Industry
Journal of Hospitality Financial Management
Causes and consequences of Cash Flow Sensitivity: Empirical Tests of the US Lodging Industr y
Financial Management Educators
CAUSES AND CONSEQUENCES OF CASH FLOW SENSITIVITY: EMPIRICAL
TESTS OF THE US LODGING INDUSTRY
Amit Sharma And
Arun Upneja ABSTRACT
The purpose of this paper is to investigate the causes and consequence of cash flow sensitivity.
While cash flow has been regarded as an agency problem, empirical investigations in context of
managerial conservatism or optimizing behavior are limited. In this paper we investigate two key
aspects of cash flow sensitivity: whether cash flow sensitivity causes variations in fixed asset
investments; and if cash flow variations are caused by managerial conservatism. Theoretical
models are empirically tested in the US lodging sector. This overall understanding of cash flow
sensitivity in the lodging industry through our study contributes to hospitality literature to the
study of liquidity management practices, capital formation, and investment behavior, and how
these are related to overall risk profile of the firm.
Introduction
Cash flows are critical for operational success of businesses, especially those in the hospitality
industry due to the shorter lifecycle of transactions, demand uncertainty, and high levels of fixed
costs. Variations in the level of internal cash flows can place financial restraints on the firm and
force it to either source external financing for operational and investment needs, or relinquish
opportunities. There are two aspects to this issue: first, how variations in cash flows impact
investments; and second, what causes variations in cash flows. Relationship between cash flow
sensitivity and investment behavior of firms has been studied extensively outside of the
hospitality industry, and remains a highly controversial issue. Part of the literature shows that
cash flow variance does impact investments while the other part of the literature claims that this
relationship is influenced by the financial constraints of the firm. Investigating how this
relationship exists in hospitality firms could provide interesting results. If cash flow demands in
these firms are indeed higher than in other industries, then one would expect that investments
will remain highly correlated to cash flow variations despite financial constraints.
However, what remains relatively obscure, are the reasons for variations in cash flows. Two
possible explanations could be hypothesized: the first reason can be that the firm is financially
constrained, assuming it is maximizing profitability. The second reason is that the management
is somehow unable to act in the interest of the owners, thereby producing suboptimal returns and
internal cash flows. The second reason has been conceptualized in the literature but has not been
empirically tested due to difficulties in identifying observable proxies for management actions.
In this paper we present a model and empirically test it to understand how management actions
may be causing cash flow sensitivities.
Two critical contributions of this investigation are as follows: first, investigating the causes of
cash flow variance will be a contribution to mainstream finance literature, and second,
understanding the correlation between cash flow variance and investments in the lodging
industry will provide an added perspective to the controversy surrounding this issue. Overall,
this paper will also help explain how lodging firms manage liquidity and make investments in
this context.
Literature Review
Fazzari et al (1988
) discuss that most investment models are based on the assumption that firms
are able to respond, through their cost of capital, to the prices set by centralized securities
market. An alternative way of analyzing investments is to emphasize the importance of internal
cash flows due to their relatively lower costs versus external funds. This approach has led to the
emergence of the literature that has analyzed correlations between cash flows and investments.
Recent imperfections that been discovered in debt and equity markets have further given
credence to this notion that firms that do not have access to external markets must mostly rely on
internal sources of funds. The paper by
Fazzari et al (1988
) marks the beginning of this
discussion (and controversy) that later emerged regarding cash flows-investments correlation.
Their investigation reveals that cash flows are indeed correlated to investments and this
correlation is particularly stronger in those firms that are financially constrained. This later
finding is challenged by Kaplan and Zingales (1997). They based their investigation on
Fazzari
et al’s (1988
) results and show an almost reverses relationship – firms that are less financially
constrained have higher correlation between investments and cash flows versus those that have
higher financial constraints. Based on these results they emphasize that (...truncated)