STRATEGIC CREDIT LINE USAGE AND PERFORMANCE

• Author: Atay Kizilaslan,Ani Manakyan Mathers
• Date: 01 June 2014
• DOI: http://doi.org/10.1111/jfir.12036
• Published date: 01 June 2014

STRATEGIC CREDIT LINE USAGE AND PERFORMANCE

Atay Kizilaslan

Cornerstone Research, New York City

Ani Manakyan Mathers

Salisbury University

Abstract

The existing literature views credit line drawdowns as a quick, low‐cost way for a firm to

access cash for immediate needs when facing a liquidity shock. We investigate whether

firms use credit lines strategically to accumulate precautionary balances in anticipation of

performance declines. We show that unexpected drawdowns, measured as the residual

from a predictive regression of drawdowns, predict increases in cash balances, future

cash flow declines, and future covenant violations. Firms with unexpected drawdowns

see less favorable terms in renegotiations than firms without unexpected drawdowns but

they are better able to finance future capital expenditures following a covenant violation.

JEL Classification: G21, G32, G39

I. Introduction

Anecdotal evidence suggests that firms strategically draw down their credit lines in

anticipation of future declines in operating performance that may impair their access to

borrowing. For example, General Motors’decision to draw down the remainder of its

credit line in 2008 raised red flags for turnaround specialist Wilbur Ross. He remarked,

“Makes you wonder if there is some danger that when the September results come out …

they’ll blow a [loan] covenant”(Humer and Erman 2008). In this article, we empirically

examine whether firms strategically time their credit line drawdowns in anticipation of

future performance declines. We hypothesize that corporations manage their liquidity

according to their future cash flow expectations because the ability to draw on a line of

credit is conditional on performance.

The theoretical literature regarding the role of bank lines of credit in firm liquidity

management generally posits that corporate credit lines are a form of insurance against

liquidity shocks (Holmstrom and Tirole 1998; Boot, Thakor, and Udell 1987). Holmstrom

We would like to thank Christopher James for his invaluable advice. We would also like to thank the editors,

Dave Blackwell, and Ken Cyree for their thoughtful comments. Our appreciation also goes out to Dominique

Badoer, Alice Bonaime, Evan Dudley, Mark Flannery, Aaron Gubin, Joel Houston, Michael Ryngaert, and seminar

participants at Binghamton University, Middle Tennessee State University, Mississippi State University, Murray

State University, Salisbury University, Texas Tech University, University of Florida, University of Texas at

Arlington, the 2012 Southern Finance Association meeting, and the 2013 Eastern Finance Association meeting for

helpful comments and suggestions.

The Journal of Financial Research Vol. XXXVll, No. 2 Pages 243–265 Summer 2014

243

© 2014 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

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and Tirole (1998) state that banks are able to aggregate liquidity across firms and

redistribute excess liquidity to those firms that need funds. Boot, Thakor, and Udell

(1987) note that committed lines of credit allow companies to pay a fee at initiation to have

access to a low‐cost source of financing if they face a liquidity shock in the future. These

theoretical models of credit lines are based on the assumption that access to a committed

line is not contingent on the financial condition of the borrower at the time a draw is

requested. However, recent empirical studies indicate that this assumption is not realistic.

Sufi(2009) finds evidence that both access to credit lines and firms’reliance on

credit lines relative to cash are increasing in the operating cash flows of the borrower. Sufi

argues that this positive relation arises from cash flow and other financial covenants

associated with bank lines of credit. Sufifinds that cash flow declines predict covenant

violations on credit lines, leading to decreased line availability as banks reevaluate the

riskiness of the borrower. More generally, negative cash flow changes predict unfavorable

renegotiations of debt contracts (Roberts and Sufi2009).

In a recent survey study, Lins, Servaes, and Tufano (2010) find that 59% of chief

financial officers do not view cash and credit lines as substitutes. They find that the

likelihood of viewing cash and credit lines as substitutes is dependent on firm cash flow,

with high‐cash‐flow firms being more likely to view the two liquidity sources as

substitutes. It seems that the existence of tight financial covenants and other conditions

placed on the use of credit lines limits the liquidity insurance that lines could provide as

lenders may refuse to provide capital when the firm needs it most.

1

Acharya et al.

(forthcoming) draw from these empirical results to propose a theory of revocable credit

lines and show the implications of revocability on the types of firms that are most likely to

use credit lines in their liquidity management. However, they do not address the potential

for strategic action by firms.

If the ability to draw on a line of credit is conditional on cash flow performance,

we expect corporations to manage their liquidity according to their future cash flow

expectations.

2

If firms have private information predicting a decline in their future

operating performance and banks condition line access on operating performance at the

time of a draw request, firms may have an incentive to preemptively draw on their lines as

a way of accumulating precautionary cash balances. We term this the availability

hypothesis.

Gamba and Triantis (2008) show that financialflexibility is associated with higher

firm values and firms can compensate for higher expectedfinancing costs by holding more

cash. Therefore, firms thatpredict a future reduction in the availability of their credit line as

a source of inexpensive financing may optimally choose to increase their cash holdings.

The availability hypothesis states that firms may access capital while it is still available,

1

Absent a covenant violation, banks must honor a credit line drawdown unless they invoke a Material Adverse

Change clause (MAC). Shockley and Thakor (1997) find that every credit line in their sample contains a MAC.

However, other studies, such as Ivashina and Scharfstein (2010), note that MACs are rarely invoked. Covenant

violations, on the other hand, occur with some frequency (e.g., Sufi2009; Roberts and Sufi2009; Nini, Smith, and

Sufi2009; Chava and Roberts 2008).

2

The motivation for drawdowns in this context differs from previous studies, such as Ivashina and Scharfstein

(2010), wherein precautionary draws are motivated by concerns about the financial performance and solvency of the

lender, though the two are not mutually exclusive.

244 The Journal of Financial Research