Financial Structure and Volatility of Firms
AbstractWe use data on privately owned firms to investigate the relationship between the financial structure of firms---specifically leverage---and their idiosyncratic volatility. From a theoretical point of view, the nexus between volatility and financial structure is a two-way stream. On the one hand, more volatile firms are discouraged from borrowing because, in the presence of operational uncertainty, leverage is risky. On the other, leverage could create the conditions for higher operational uncertainty. Both streams could be relevant in practice: firms facing higher operational volatility choose to borrow less (from volatility to leverage) and firms that are more leveraged experience higher idiosyncratic volatility because of the higher leverage (from leverage to volatility). Although it is difficult to separate these two streams empirically, the sign of the relationship could inform us, indirectly, about their prevalence: a negative correlation could be indicative of the prevalence of the first channel (from volatility to leverage) while a positive correlation could be indicative of the prevalence of the second channel (from leverage to volatility). Using firm-level data for a cross-section of US privately-owned firms we find that more leveraged firms display higher operational volatility (sales, earnings and profits). This suggests that the causal link going from leverage to volatility may be more important. We also replicate these findings using data from European firms.
This finding is important for understanding the economic recovery in the aftermath of the COVID-19 crisis. The profitability collapse that many businesses are currently experiencing will result in increased debt burdens. This is likely to increase their idiosyncratic uncertainty which will discourage investments once the pandemic is under control. The consequence could be a much slower and longer recovery with sluggish investment.