Ali Kakhbod, A Max Reppen, Tarik Umar, Hao Xing
Review of Finance, Volume 29, Issue 3, May 2025, Pages 661–683, https://doi.org/10.1093/rof/rfaf008
In this study, we ask a simple yet fundamental question: does a firm’s cash holdings always rise in tandem with its size? While classic theory and early empirical evidence suggest that larger firms hold more cash, we uncover a strikingly different pattern among small firms. For these smaller companies, a negative correlation emerges: as they grow, their cash reserves actually shrink.
To explain this finding, we enrich a standard firm liquidity management model by allowing investment opportunities and external financing costs to vary with firm size. In our model, when firms are small, they face a mismatch between strong investment incentives and limited internal cash flow generation. Because external funds are costly and issuance comes with frictions, small firms stockpile cash to finance growth, mitigate financing constraints, and avoid expensive equity issuance. This motivation leads to relatively large cash holdings at small firm size.
However, as these firms scale up, two critical changes occur. First, their investment opportunities diminish in intensity, reducing the urgency to hold large cash balances. Second, rising internal cash flows increasingly cover their future investment needs. Consequently, moderately sized firms allow their cash reserves to drift downward rather than fully replenishing them after each project. Thus, as firms transition from very small to medium-sized, we observe a negative relationship between size and cash.
The pattern eventually reverses once firms become large enough. At substantial scale, the nature of the firm’s problem changes. Large firms now face proportionally larger shocks, and their main concern shifts from funding investment to buffering against increased cash flow volatility. With scale, even modest percentage fluctuations in revenue translate into large nominal shocks, prompting firms to rebuild cash buffers. At this stage, the classic prediction reemerges: as firm size continues to increase, so do cash holdings.
Using a dataset encompassing 11.2 million European firms, we document this U-shaped pattern empirically. The data confirm that small firms hold proportionally more cash and reduce their reserves as they grow, while larger firms, consistent with traditional frameworks, build up greater cash balances.
By integrating size-dependent investment opportunities and financing constraints into the modeling framework, our analysis highlights that the relationship between firm size and cash holdings is not universal. Instead, it evolves with the firm’s scale, shifting from an investment-driven motive when small to a volatility-buffering motive when large.