Financial leverage and firm efficiency: the mediating role of cash holding

Agency cost theory suggests that a firm's financial leverage is important to improve organizational efficiency. Using data of industrial companies of three biggest economies, this study analyzes how debt-financing decision affects firm efficiency and the mediating role of cash holding. We find inverted U-shape relationship between the level of financial leverage and firm efficiency. This implies that firms with optimum capital structure achieve high efficiency. The cash-holding level of the companies negatively relates to the efficiency. We also document that the firms' that apply more financial leverage are less likely to hold excess cash balances and that the cash holding partially mediates the relationship between the financial leverage and the firms' efficiency. This suggests that the use of debt financing has the potential to enhance firm efficiency by effectively tapping the free cash flow that would have been misused by the management. The results have important implications for corporate finance since it highlights how financial decisions determine corporate productivity.