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Transitory and Permanent Cash Flow Shocks in Debt Contract Design
Published online by Cambridge University Press: 24 February 2025
Abstract
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We examine how lenders design contracts to account for transitory and permanent cash flow shocks facing borrowers. We find that volatile transitory cash flow shocks are associated with fewer liquidity covenants, indicating financial flexibility that enables firms to survive liquidity crunches. The opposite is true for volatile permanent cash flow, suggesting that borrowers’ economic fundamentals are important credit risk factors. Subsequent analyses show that borrowers exposed to transitory (permanent) shocks face less (more) severe credit consequences following poor performance. Overall, we show that transitory and permanent cash flow shocks have significant and opposite effects on debt contract covenant design.
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This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.- Copyright
- © The Author(s), 2025. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington
Footnotes
We are grateful for helpful comments and suggestions from the editor, the anonymous referee, Daniel Aobdia, Kai Du, Bingxu Fang (discussant), Kurt Gee, Dan Givoly, Paul Healy, Steve Huddart, Henock Louis, Rick Mergenthaler, Jed Neilson, George Serafeim, Kavi Thakkar (discussant), Biqin Xie, and seminar participants at Penn State University, Syracuse University, and the 2022 Haskayne and Fox Accounting Conference. All errors are our own.
Funding: We acknowledge financial support from Harvard Business School, University of Technology Sydney, Xi’an Jiaotong-Liverpool University (XJTLU Research Development Funding RDF-21-02-002), grants 72342022 and 72141304 from the National Natural Science Foundation of China, and Accounting and Finance Association of Australia and New Zealand Research Grant.
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