Firm Cash Holdings, Idiosyncratic Risk and Analyst Coverage

Abstract

This article examines how idiosyncratic risk and degree of analyst coverage affect firms’ cash holdings and shareholders’ valuation. To disentangle business and nonbusiness risk, we decompose idiosyncratic risk into two components: (i) cash flow, or business, risk and (ii) residual, or nonbusiness, risk. Analyst coverage has been shown to improve performance and governance. We find that idiosyncratic risk has a negative effect on cash holdings, controlling for cash flow volatility. This finding runs contrary to the precautionary savings motive and suggests that endogenous high idiosyncratic risk is cash destroying. Yet further investigation reveals that firms with high idiosyncratic risk have small cash reserves only when analyst coverage is low. Firms with large cash reserves are likely to barely beat analysts’ forecasts only when their earnings are low. For firms with intense analyst coverage, their business risk has a positive effect on the market value of cash, whereas their nonbusiness risk has a negative effect.