Financial Leverage and Firm Performance: The Moderating Role of Cash Holdings

Abstract

Firms with higher managerial ability are likely to invest more efficiently, especially when they have excess liquidity. Managerial ability is one of the most important determinants of firm efficiency, but regulatory mechanisms complement the effect of intelligent managers on investment efficiency. Capital structure decisions reduce organizational inefficiency by constraining managers' investment behavior. Koussis et al. [1] argue that managers may need to invest more optimally in growth options and lead their firms with high agency costs. High debt financing through asset diversion reduces the inefficiency of the final investment and managers who spend wastefully. The threats posed by managers' inability to meet their debt financing needs are the driving force behind making organizations more effective. Using more debt in the capital structure provides an opportunity to control managers' spending behavior and reduce the problems of overinvestment. However, excessive use of financial leverage increases agency costs and can lead to another type of inefficiency. Therefore, companies need to borrow up to an optimal debt level, called debt capacity. Research has shown that increasing financial leverage, due to the regulatory role of debt, improves firm performance.