Corporate Financial Leverage in Canadian Manufacturing: Consequences for Employment and Inventories

Canadian Journal of Administrative Sciences, Jun 2004 by Heisz, Andrew, LaRochelle-Côté, Sébastien

Abstract

This paper investigates the link between financial structure and employment growth and the link between financial structure and inventory growth, among incorporated Canadian manufacturers over the period 1988 to 1997. It. finds that financially vulnerable firms-smaller firms and those with higher leverage-tend to shed more labour than healthier firms for an equal sized drop in product demand. When a demand shock occurs, a firm with high leverage sheds nearly 10% more employment for than a firm with average leverage. The influence was larger during the recession of 1990-1992 and more significant in sectors that were hit hardest by the recession. This is as one would expect given that credit constraints become more binding during recessions. The influence was also larger in sectors that experienced larger cyclical fluctuations. On average, firms with high leverage also tend to cut inventories more ( 5%) when a shock in demand occurs.

Résumé

Cette étude porte sur le lien entre la structure financière et la croissance de l'emploi et des inventaires des fabricants canadiens constitués en société au cours de la période allant de 1988 à 1997. On observe que pour une certaine baisse dans la demande de produits, les entreprises financièrement vulnérables-c'est-à-dire celles qui sont de petite taille ou qui ont un ratio de levier financier élevé-ont tendance à réduire davantage leurs effectifs que les entreprises en meilleure santé financière. Lorsqu 'un choc à la baisse survient dans la demande de produits, les coupures d'emploi sont près de 10 % plus élevées dans les entreprises avec un ratio de levier financier élevé, en comparaison avec les entreprises dont le ratio se situe dans la moyenne. Cette influence était plus marquée durant la récession de 1990 à 1992, et était plus significative dans les industries qui ont été plus durement touchées par la récession. Ce résultat n'est pas surprenant dans la mesure où les conditions de crédit sont plus contraignantes en période de récession. Enfin, les entreprises avec un ratio de levier financier élevé tendent à réduire davantage leurs inventaires (dans une proportion de 5 %) lorsque survient un choc de la demande.

During recent decades, Canadian businesses increasingly financed themselves by raising their level of debt with respect to assets, commonly referred to as leverage. Between 1961 and 1996, the share of Canadian firms' capital held in debt increased by nearly 50%.1 In the 1990s, the level of aggregate corporate leverage tended to fall slightly, but still remained high by historical standards. Does this increase in leverage matter? Capital structure theory beginning with Modigliani and Miller (1958) argues that the choice of capital structure does not matter to the net value of the firm or the cost of available capital. Divergences from this theorem, described by Donaldson (1963), Jensen and Meckling (1976), Myers (1977, 1984), Myers and Majluf (1984), and Fama and French (2002) emphasize the role of informational asymmetries and agency costs which differentiate the cost of external and internal finance, making capital structure choice important for the firm's value and for the cost of capital available to the firm. This has implications for the real side activity of the firm, including employment and investment in inventories.

In this paper we examine the relationship between firm leverage and stability in employment and inventories using Canadian data for the manufacturing sector. Recent empirical studies focusing on the U.S. manufacturing sector have shown that highly leveraged firms have more volatile inventory and employment patterns. In the event of a negative demand shock, firms must find new funds to finance variable inputs. A firm with a healthy balance sheet position may have the cash on hand, or easy access to external finance, to smooth production by building up inventories (Blinder & Maccini, 1991) and avoid the large adjustment costs associated with the firing (and hiring when demand picks up later) of employees (Nickell, 1986; Oi, 1962). On the other hand, if a firm has difficulty obtaining outside finance, its employment and inventories should be more sensitive to the availability of internal funds. Cash flows at highly leveraged firms tend to be committed to principal and interest payments, and lenders may see the firm as having reached its maximum debt capacity. Hence, the cost of additional debt to a financially distressed firm is likely to be high. As a result, leveraged firms will tend to lay off workers (Sharpe, 1994) and allow inventories to decline (Carpenter, Fazzari, & Petersen, 1994; Kashyap, Lamont, & Stein, 1994). Alternatively, firm owners may prefer higher debt to force firm managers to respond quickly to changes in the economic environment (Jensen, 1986, 1988). In either case, employment and inventory instability is the outcome.

Similar arguments have been put forth regarding small firms. Small firms also face capital market constraints since they often do not have access to equity markets and often need to finance their operations with more expensive bank loans. Thus, small firms are often also seen as financially constrained and more sensitive to demand shocks than large firms (Gertler & Gilchrist, 1994; Gertler & Hubbard, 1988).