Cash Holdings and Labor Heterogeneity: The Role of Skilled Labor

Mohamed Ghaly is Assistant Professor of Finance at Lancaster University and Konstantinos Stathopoulos is Professor of Accounting and Finance at the University of Manchester’s Alliance Manchester Business School. This post is based on a recent article by Professor Ghaly, Professor Stathopoulos, and Viet Anh Dang, Associate Professor of Finance at the University of Manchester’s Alliance Manchester Business School.

In today’s competitive labor market, many firms are facing challenges in recruiting and retaining talent. The Manpower Group, a leader in human resource consultancy, has been conducting a worldwide “Talent Shortage Survey” in recent years. In 2015, 38% of 41,000 employers in 42 countries reported difficulty filling jobs due to lack of available skills. In the presence of skill shortages firms should hold onto their valuable hard-to-replace human capital, even during economic downturns. But what are firms prepared to do in their efforts to keep skilled employees? In our article, Cash Holdings and Labor Heterogeneity: The Role of Skilled Labor, which was recently accepted for publication in the Review of Financial Studies, we examine how firms’ cash reserves are determined by their reliance on skilled workers. We show that firms with a higher share of skilled workers hold more precautionary cash.

Why does skilled labor matter for corporate cash policy? We argue that cash holdings are important to firms facing labor market frictions due to the presence of costly labor adjustment. When a firm adjusts its labor demand, it incurs the costs of firing, search, selection, hiring, and training, as well as costs associated with productivity losses. In the presence of labor adjustment costs (LACs), a firm cannot adjust its labor demand costlessly and has an incentive to minimize its labor turnover (Dixit 1997). Failure to follow this optimal labor retention policy is particularly costly for firms relying on skilled employees, who are more likely to receive higher severance payments or file lawsuits if fired. Furthermore, searching, hiring, and training employees are more costly, for jobs that require advanced technical skills, which are usually in shorter supply (Blatter, Muehlemann, and Schenker 2012). This difficulty means that replacing skilled workers typically takes longer (Oi 1962), causing greater disruption to productivity. In addition, employee layoffs, as a cost-cutting response to demand slumps, have a negative effect on a firm’s stock price performance (Farber and Hallock 2009); the higher the skill level of the human capital laid off, the more pronounced the effect (Milanez 2012).

The above arguments suggest that firms should avoid making costly labor adjustments by optimally maintaining employment at a stable level. This labor retention policy, however, exposes them to the risk of not being able to mitigate the impact of future cash flow shocks. Firms will have an incentive to hold precautionary cash to reduce this risk because cash reserves act as a buffer that safeguards against future cash flow uncertainty (Almeida, Campello, and Weisbach 2004), thus enabling firms to maintain their optimal employment policy. This precautionary motive for holding cash should be stronger for firms that depend heavily on skilled workers.

To test this prediction, we construct an industry-specific labor skill index (LSI) based on Occupational Employment Statistics (OES) data from the Bureau of Labor Statistics (BLS) and the O*NET program classification of occupations according to skill level. Using LSI as a measure of labor skills, we find strong evidence that firms operating in industries with a higher share of skilled workers hold larger cash balances. The impact of LSI on cash holdings is economically significant: A one standard deviation increase in the index is associated with an increase in the cash-to-assets ratio of 4.2 percentage points. We also find that firms with a higher share of skilled labor have a higher propensity to save cash from their cash flows and enjoy a higher market value of cash, which further highlights the importance of cash reserves for high-skill firms. Additional analysis further shows that firms respond to high LACs associated with high labor skill levels by not only maintaining high cash balances but also low financial leverage.

We then examine variation in the LSI-cash holdings relation. We find the impact of labor skills on cash to be stronger in labor markets with higher downward adjustment costs and weaker in labor markets with lower upward adjustment costs. We also observe that the positive relation between LSI and cash continues to hold after controlling for exogenous differences in hiring and firing costs, suggesting that the effect of LSI, as a broader measure of LACs, on cash is above and beyond that of individual proxies for LACs used in prior literature (e.g., employment protection laws). Furthermore, consistent with the precautionary savings motive, we find the effect of LSI on cash holdings to be stronger for firms that are financially constrained.

A major concern with a causal interpretation of the relation between LSI and cash holdings is the potential endogeneity of labor skills. A firm’s share of skilled labor may be endogenously chosen and related to unobservable factors that also affect its cash holdings, leading to a spurious correlation. Reverse causality poses yet another concern. A firm’s cash holdings may affect its ability to recruit skilled workers, implying causality from cash to LSI. We address those endogeneity concerns through three different strategies. First, to reduce firm and industry heterogeneity bias, we rerun our analyses using subsamples of industries and firms with reasonably similar observable and unobservable characteristics. Second, we perform a series of propensity score matching (PSM) analyses to reduce heterogeneity along many dimensions. Our subsample and PSM results again show that firms with greater reliance on skilled labor hold more cash. Third, we exploit an exogenous shock to the labor supply as a result of labor migration from New Orleans to Houston following Hurricane Katrina in 2005. Between 100,000 and 150,000 evacuees made the move, representing a 3%-4% increase in the Houston population (McIntosh 2008). Given that those evacuees consisted of both highly and low-skilled workers (Gabe et al. 2005; McIntosh 2008; De Silva et al. 2010), the Katrina-induced increase in the labor supply should have increased the thickness (i.e., the number of effective participants) of Houston’s local labor market (Moretti 2011) and therefore resulted in lower LACs on average for firms headquartered in Houston compared to matched control firms in neighboring metropolitan areas. Our difference-in-differences and triple difference results show that the change in cash holdings from pre- to post-Katrina was more negative for Houston-based firms than for matched control firms. In addition, the negative impact of the Katrina-induced labor migration on the cash holdings of Houston-based firms was more pronounced for those with a greater share of skilled workers.

Finally, we address a concern that our results may be driven primarily by the intangible capital channel rather than LACs; under this alternative channel, for example, high-labor-skill firms would build up cash reserves mainly to protect valuable intangible assets rather than skilled labor. Although the two channels are not mutually exclusive and are thus difficult to disentangle, our tests show that the LSI-cash holdings relation remains positive and significant when we control for intangible capital using proxies established in recent studies (Peters and Taylor 2017) or concentrate on firms that have limited intangible capital.

Overall, our article provides novel evidence on the interaction between workers’ skill level and firms’ financial policies. Our findings highlight the importance of skilled labor and its adjustment costs as an overlooked determinant of corporate cash holdings. One relevant implication of our study is that firms relying on skilled workers and following a labor retention policy should consider adopting conservative financial policies through accumulating cash reserves.

The complete article is available for download here.

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