The Journal of Financial Research


Finance / Accounting



Atay Kizilaslan

Cornerstone Research, New York City

Ani Manakyan Mathers

Salisbury University


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, andUdell 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



FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING 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. Sufi finds 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 Sufi 2009).

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 financial flexibility is associated with higher firm values and firms can compensate for higher expected financing costs by holding more cash. Therefore, firms that predict a future reduction in the availability of their credit line as a source of inexpensive financing may optimally choose to increase their cash holdings.