Financial flexibility and social distancing in the face of disaster : an empirical study on the US stock market during the COVID-19 pandemic

Abstract

The objective of our study is to examine the mechanisms of the corporate balance sheet during the exogenous COVID-19 crisis. The Fama-MacBeth methodology is employed on the US stock market, controlling for industry and common market risk factors. We argue that financially flexible firms, i.e. firms with more cash and less debt, should have less risk and be better shaped than their inflexible counterparts to fund a revenue shortfall. We find that financially flexible firms have 12.4% higher returns than inflexible firms when using book leverage, and 20.5% when using market leverage. The higher returns correspond to a 23.2% and 38.4% lower stock price reduction for the flexible firm, dependent on debt metrics. We document that the return gap between financially flexible and inflexible firms remains fairly constant throughout the market recovery, and hence that our results can not be due to the increased elasticity of equity. We argue that market leverage is a better overall measurement of debt capacity and firm risk. When addressing industry exposure to COVID-19, we claim that the importance of financial flexibility should be magnified (reduced) for firms with high (low) fundamental exposure. We do not find that resilient firms benefit less from financial flexibility. Exposed firms gain from higher cash holdings prior to the stock market crash. This effect seems to be reversed after the FEDs market intervention on March 23rd, although the results are ambiguous. Market leverage suggests no magnified effect from debt for exposed firms. However, again our metrics provide conflicting results. Also here we argue that market leverage is more in line with economic rationale.