Corporate Funding: Who Finances Externally?

In our paper, Corporate Funding: Who Finances Externally?, which was recently made publicly available on SSRN, we provide new information on security issues and external financing ratios derived from annual cash flow statements of publicly traded industrial companies over the past quarter-century. Our use of cash flow statements permits us to differentiate between competing forms of internal financing, including operating profits, cash draw-downs, reductions in net working capital, and sale of physical assets. Unlike leverage ratios which dominate the focus of the extant capital structure literature, our cash-flow-based financing ratios are measured using market values (cash) and are unaffected by the firm’s underlying asset growth rate.

The empirical analysis centers around three main issues, the first of which is to establish the importance of external finance in the overall funding equation. In our pool of nearly 11,000 (Compustat) non-financial firms, the net contribution of external cash raised (security issues net of repurchases and dividends) was negative over the sample period. Moreover, the average (median) firm raised merely 12% of all sources of funds externally. Also, annual funds from total asset sales contributed more to the overall funding equation than net proceeds from issuing debt.

We also study the stability of cash financing patterns over time after the year of the IPO. As it turns out, shortly after the IPO year, net debt issues constitute a small but stable source of funds for the average firm, with most debt issues designed to roll over existing debt contracts (a dollar of debt coming due is financed by issuing new debt). When we sort firms on high and low leverage ratios in the year of the IPO, we find that leverage ratios for these portfolio sorts revert to a long-term average. Surprisingly, an important part of this leverage adjustment occurs through asset sales and purchases: firms with low initial leverage ratios subsequently adjust up through substantial asset sales, while firms with high initial leverage adjust down through a combination of high profits and a decreasing reliance on external debt. Equity issues are primarily used to finance negative operating cash flows, and then mostly by small growth firms.

To answer the follow-up question “who issues debt?”, we first document the frequency and size of net debt issues (debt issues in excess of debt repurchases or rollovers). Using annual counts, the median sample firm issues positive net debt only twice over the sample period. However, there is a small fraction of firms, which issues debt very frequently. Relative to these high-frequency issuers, low-frequency issuers are on average substantially smaller and less profitable, and they issue large amounts relative to firm size. We also show that, in an average sample year, the top 200 debt issuers are responsible for 84% of the total volume of net debt issues.

Next, we estimate the issue cost function for observed public debt and equity issues and find that infrequent issuers face issue costs that differ in interesting ways from that of high-frequency issuers: the least frequent debt issuers have fixed costs which are significantly greater than zero while the most active firms have insignificant fixed issue costs. This cost difference make sense from a simple cost-minimizing perspective and is consistent with the average firm characteristics.

Last but not least, we contribute towards a resolution of a long-standing puzzle in the capital structure literature – that the correlation between leverage ratios and the level of firm profitability appears to be negative and not positive as predicted by classical tradeoff theories of debt. Interestingly, after splitting operating cash flow (profitability) into a positive and negative component, we discover that the correlation between net debt issues and the positive component is positive and significant In other words, whoever issues debt tends to do so in periods with positive operating cash flow.

The overwhelming reliance on internal finance seems highly relevant for the ongoing debate over whether or not firms have meaningful leverage targets as suggested by classical tradeoff theories. An interesting question for future research is whether the degree of internal finance, and the concentration of debt issue proceeds in a few firms, can reasonably be explained by dynamic, investment-based capital structure theories. On the positive side, our evidence of an apparent issue-cost optimization fits a basic premise of virtually all capital structure theories involving external financing. However, at a minimum, the dominance of internal funds and rarity of positive net debt issues suggests that external financing costs are greater than anticipated by simple adverse selection arguments under asymmetric information.

The full paper is available for download here.