MID-TERM ASSIGNMENT (CRITICAL DRAFT)
Module: Corporate & Quantitative Finance (RKC)
CRN: 52950
Level: 7
Assessment: Mid-Term Assignment (Work-in-Progress)
Title: Liquidity Decisions During Financial Crises: A Critical Analysis
Student Name:
EXECUTIVE SUMMARY
This report will critically analyse the liquidity decisions made by firms in the event of a
financial crisis by combining current theories of corporate finance with the recent empirical
research. Liquidity management is central in the face of systemic shocks like the Global
Financial Crisis and the COVID-19 pandemic, when companies are under tough financing
strains and an increased level of uncertainty. Although previous theories, such as trade-off
and pecking order theories, can be used to describe the baseline liquidity behaviour, recent
analyses imply that crisis environments can change these dynamics considerably.
The report suggests that liquidity choices can be motivated by the interaction of internal
factors, including cash flow management, leverage and asset restructuring and external
factors such as market volatility, policy interventions, and investor sentiment. The findings
show that better resilience, accompanied by increased pre-crisis cash holdings exist, but
excessive liquidity can decrease investment efficiency. The report concludes that optimal
liquidity is a situational matter and that a balance between precautionary motives and value
maximisation is advised.
TABLE OF CONTENTS
1. INTRODUCTION............................................................................................................................................
2. THEORETICAL FRAMEWORK....................................................................................................................
2.1 Trade-Off Theory......................................................................................................................................
2.2 Pecking Order Theory...............................................................................................................................
2.3 Agency Theory and Governance...............................................................................................................
2.4 Precautionary Motive................................................................................................................................
3. INTERNAL DETERMINANTS OF LIQUIDITY...........................................................................................
4. EXTERNAL DETERMINANTS OF LIQUIDITY..........................................................................................
5. EMPIRICAL EVIDENCE AND CASE INSIGHTS........................................................................................
6. ECONOMETRIC FRAMEWORK...................................................................................................................
7. CRITICAL DISCUSSION................................................................................................................................
8. CONCLUSION.................................................................................................................................................
REFERENCES......................................................................................................................................................
1. INTRODUCTION
Liquidity management is a critical issue of corporate finance, especially at a time when the
economic situation is unstable. Liquidity is the capability of a firm to fulfil short-term
commitments without getting into unnecessary expenses and financial suffering. In crises like
the Global Financial Crisis and the COVID-19 pandemic, a firm is exposed to extreme cash
flow shocks and limited availability of external finance, as these increase the degree of
liquidity risk. It has been empirically observed that companies counteract it by hoarding cash
and tapping into credit facilities in precautionary steps (Almeida, 2021).
There are, however, major trade-offs in liquidity decisions. Although increased cash levels
can increase the company's resilience and minimise the risk of bankruptcy, too much liquidity
can affect investment efficiency and lower firm value (Tawiah and Keefe, 2022). Thus, this
report critically assesses the precautionary motives balance and value maximisation under
crunch conditions by firms.
2. THEORETICAL FRAMEWORK
2.1 Trade-Off Theory
The trade-off theory indicates that companies trade off the marginal character of the benefits
and costs of holding liquidity. The positive aspect of having liquidity benefits is amplified in
times of crisis, where it will be required to be out-of-bankruptcy and allow the available
flexibility of operation. Nevertheless, the cost of having idle money is still high.
The recent empirical findings dispute the rarefied use of this theory. As an example, it is
found that an increase in cash holdings can increase recovery following a crisis, but it can
also affect investment efficiency (Ardianto and Sulaiman, 2024). This implies the fact that
the trade-off is not absolute but relative, especially in extreme situations of the economy.
2.2 Pecking Order Theory
The pecking order theory states that firms utilise internal financing as a result of information
asymmetry. External finance is expensive or unavailable in times of crisis, which further
supports the necessity of internal liquidity.
This behaviour is validated by empirical research in the period of the COVID-19 pandemic,
as companies accumulated more cash and used external financing extensively (Almeida,
2021). This theory, however, has weaknesses in explaining why certain firms have
accumulated super-liquidity beyond the precautionary requirements, signifying that it has
limitations in its explanatory capacity.
2.3 Agency Theory and Governance
Agency theory emphasises that managers can pursue their own interests instead of
shareholder value, resulting in an inefficient liquidity choice. Large cash balances could
represent aversion to risk taken by managers, or an empire-building motive, as opposed to an
efficient financial policy.
According to recent studies, the setup of governance has an impact on liquidity. As an
illustration, the association between cash holdings and investment efficiency may be
moderated by the nature of the board, demonstrating the implications of corporate
governance in the liquidity decision (Ardianto and Sulaiman, 2024).
2.4 Precautionary Motive
The precautionary motive is also applicable, especially in the impact of crises. Cash is
retained by firms as insurance against uncertainty and financial tightness. This theory is
highly empirically validated as it indicates that during times of increased uncertainty,
companies accumulate large amounts of cash reserves (Chung et al., 2023).
The precautionary motive, however, brings up a very important question: to what extent is
liquidity optimal? Research shows that liquidity is positive, but marginal returns are
decreasing; that is higher the liquidity, the lower the value of the firm.
3. INTERNAL DETERMINANTS OF LIQUIDITY
The internal elements are significant in influencing the decision of liquidity. Companies are
keen on the fluidity of cash, assets, and debt levels to ensure liquidity during crisis periods.
Cash flow management entails increasing the tightening of receivables and postponing
payment. Though this can work in the short run, it can put a strain on the relationship existing
between stakeholders, and it can break the supply chains. Asset management and the
realisation of non-core assets can offer liquidity with little time, but have a high likelihood of
causing fire sales losses, which is not too good in the long term.
The other important consideration is debt management. Through precautionary borrowing,
companies that suffered the COVID-19 crisis experienced a loss of cash reserves and
proceeded to borrow more funds through long-term debts to widen credit lines (Almeida,
2021). This behaviour indicates a turnaround of the conventional financing strategies into
preserving liquidity.
But such internal strategies have their limits. Weak financial performances can mean loans
are not available to firms, hence the significance of financial health pre-crisis.
4. EXTERNAL DETERMINANTS OF LIQUIDITY
The external factors are crucial in impacting the liquidity decisions made by firms, which in
many cases limit or facilitate the internal strategies.
During crises, the market conditions become characterised by poor liquidity and volatility. A
failure of the Lehman Brothers showed us that liquidity can be lost very rapidly with
contagious effects across the system.
The role of government interventions is important to stabilise markets. To promote liquidity,
the central banks, including the Federal Reserve, used massive monetary policy, namely
credit facilities and quantitative easing. There is proof of such intervention, which enhanced
market liquidity and eased financing limitations (Kargar et al., 2021).
The confidence of investors also has an influence on the ability of firms to attract capital.
Companies that have good reputations and credit scores are in a better position to receive
funds during the crisis, as the weak companies are severely limited. Also, uncertainty is
found to be one of the main factors behind corporate cash holdings, particularly
overshadowing the financing costs (Chung et al., 2023).
5. EMPIRICAL EVIDENCE AND CASE INSIGHTS
Empirical research conducted in recent years offers useful information about the behaviour of
liquidity during a crisis. It has been demonstrated that companies with large cash holdings
before the crisis perform better and recover faster (Chang and Yang, 2022). Likewise, under
COVID-19, companies which had good cash reserves had less serious performance
drawbacks (Zheng, 2022).
These findings are, however, not unanimous. Some studies show that high cash holdings
decrease the efficiency of investment, specifically in the case of a crisis (Ardianto and
Sulaiman, 2024). This brings out a conflicting matter of resilience versus efficiency.
This complexity is further evidenced by the phenomenon of the dash for cash that was
observed in the period of COVID-19, in which companies actively increased liquidity by
drawing down credit lines, which speaks to increased precautionary behaviour (Bc and
Simpson, 2023). As this strategy contributed to the survival in the short-term, it also made
leverage and financial risk higher.
6. ECONOMETRIC FRAMEWORK
To analyse liquidity decisions, an econometric equation can be defined:
This model allows estimating the role of the crisis and firm-specific features in determining
liquidity. Nevertheless, the major econometric problems that should be considered through
empirical analysis are endogeneity, omitted variable bias, and multicollinearity.
More recent research also uses sophisticated methods like fixed-effects models and the
difference-in-differences designs to enhance causal inference (Zheng, 2022). Use of these
techniques enhances the soundness of research and is congruent with current quantitative
financial methodology.
7. CRITICAL DISCUSSION
Through the analysis, it is possible to conclude that liquidity choices in the financial crisis are
complex and contextual in nature. Traditional theories could also offer a good framework, but
do not describe the dynamic and uncertain environment of crises in detail (Gujarati, 2015).
The main weakness of the current literature is that there has not been a consensus on the
optimal level of liquidity. Greater cash means more resilience, but also can cause inefficiency
and low firm value. Additionally, behavioural factors, governance structures, and institutional
environments affect liquidity choices, which are ignored by theoretical frameworks (Harjoto
et al., 2018).
Also, though stabilising the markets, government interventions can become a distortion in the
behaviour of firms and lead to moral hazard. Companies can overpromote dependence on
external assistance, which will diminish the motivation to take measures when risks are
managed.
8. CONCLUSION
This report has critically analysed the liquidity decisions by firms in times of financial crisis
by combining both the theoretical and empirical points of view. These results point out the
significance of internal and external factors in developing liquidity strategies.
Although liquidity is an essential cushion against financial distress, the optimal level is
unclear. Companies have to live with safety interests and efficiency interests, in order to
create value to the maximum. This analysis shall be further elaborated in the final report to
add more empirical evidence, sophisticated econometric methods, and critical analysis.
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