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If one customer accounts for a large portion of a supplier's sales, then the loss of that one customer can cripple the supplier's financial health. As a precaution against the additional operating risk induced by being in an important relationship with a customer, I find that suppliers in such relationships hold more cash on average than suppliers that are not in important relationships. Additionally, supplier's cash holdings increase proportionately with the importance of their customer relationships. Being in an important relationship affects cash holdings and leverage differently, indicating that firms manage cash and debt for different purposes. I find that suppliers in relationships primarily accrue cash through issuance of stock as opposed to debt or retained earnings. The results highlight the importance of understanding buyer–supplier relationships when evaluating a firm's financing policy.

Two recent trends in corporate business practices have contributed to an increase in both the prevalence and importance of buyer–supplier relationships. First, we have witnessed a decline in the vertical integration and industrial diversification of firms which has given rise to a host of new buyer–supplier relationships.1 Simultaneously, instead of choosing a trading partner based solely on price, many American companies have shifted their overall business-to-business strategy to focus on a few key partners to create enduring trading relationships which encourage teamwork, foster innovation, and enhance product quality (Emshwiller, 1991). These long lasting relationships, based largely on implicit contracts, create both costs and benefits for the supplier. Despite the dramatic increase in both the prevalence and importance of relationships, there is little empirical evidence of how the costs and benefits of buyer–supplier relationships affect firm financial policy. This paper investigates when and how buyer–supplier relationships affect one aspect of a supplier's financial policy, namely cash holdings. I hypothesize that suppliers in relationships should hold additional cash as a precautionary measure. If one customer comprises a large portion of the supplier's sales, then the loss of that one customer will result in a large adverse cash flow shock resulting in financial distress. Firms recognize and acknowledge the additional risk partnerships pose. For example, in their June 28, 2003 annual 10-K statement, Salton Inc. reported, “If we were to lose one or more of our major customers, our financial results would suffer.”2 As a result, suppliers in relationships might hold additional cash as a precaution. As predicted, I show that firms in important relationships do indeed hold more cash. Further, I find that as the importance of the relationship increases, measured by the percent of sales and sales concentration to important customers, so does a supplier's cash holdings. Quantitatively, the estimates imply that a one standard deviation increase in customer concentration is associated with an 8% increase in the cash ratio. To put this in perspective, a one standard deviation change in the R&D ratio used as a proxy for the relative cost of financial distress (Opler et al., 1999) is associated with a 7.5% increase in the cash ratio. I find that the proportion of firms which reports having a major customer increases over time and that suppliers in relationships hold more cash on average than firms not in relationships. Therefore, the puzzle of the increase in overall cash holdings over time reported by Bates et al. (2009) may be partially explained by firm relationships. My results are robust to proxies for the degree of relationship dependence such as supplier's industry, R&D spending, and industry Herfindahl–Hirschman Index. I find that regardless of the manufacturer's type the relation between customer importance and cash holdings is positive and statistically significant. Further, the effect of a buyer–supplier relationship on cash holdings is distinct from the effect on (negative) debt. While only some suppliers in relationships maintain lower leverage (as shown by Banerjee et al. (2008), Kale and Shahrur (2007), and confirmed here), all suppliers in relationships hold additional cash. This is a unique and important finding given the traditional view of cash as negative debt. This paper makes important contributions in several areas of corporate finance. First, the results contribute to understanding the determinants of corporate cash holdings. Bates et al. (2009), Haushalter et al. (2007), Opler et al. (1999), and Subramaniam et al. (2011) find that firms hold cash for precautionary reasons. My results compliment and extend this research by showing that even after controlling for the sources of risk previously documented firms hold additional cash specifically as a precaution against buyer-induced risk. Additionally, I contribute to the ongoing discussion of when cash is distinct from negative debt (Acharya et al., 2007). Banerjee et al. (2008), Kale and Shahrur (2007), and Titman and Wessels (1988) all conclude that firms maintain lower leverage as a commitment to their buyers. The analysis reveals that the strategic motive of maintaining lower leverage as a commitment to buyers is markedly distinct from the precautionary motive for holding cash due to the risk posed by being in a significant relationship with a buyer. Finally, this study contributes to the growing body of literature which investigates how corporate financial decisions are affected by strategic interactions between buyers and suppliers. To date researchers have examined the effect of inter-firm relationships the following factors, including sales, profit margin, transaction costs (Kalwani and Narayandas, 1995), distress costs (Hertzel et al., 2008), information transmission costs (Gomes-Casseres et al., 2006, Johnson et al., 2010a and Johnson et al., 2010b), bargaining power (Brown et al., 2009 and Fee and Thomas, 2004), investment-cash flow sensitivity (Itzkowitz, 2012), and leverage (Banerjee et al., 2008, Kale and Shahrur, 2007 and Titman and Wessels, 1988). Most recently, a working paper by Bae and Wang (2010) examined the effect on cash holdings. While I echo their general finding, this paper significantly furthers their work by showing why this is the case. By comparing the effects of a relationship on cash holding with the effects on leverage, this paper provides strong support for the precautionary motivation. Finally this paper bolsters Banerjee et al. (2008) and Kale and Shahrur (2007) findings that firms in major buyer–supplier relationships have a more conservative financing policy in two distinct ways. First, whereas the previous work focuses on debt management, I show effects on cash holdings. Second, for firms in relationships, I find that the motivation for additional cash holdings (precaution) is distinct from that of debt management (commitment).

Both the number of suppliers reporting relationships and the strength of these reported relationships (measured by both percent of sales to the customers and sales concentration) have increased over time. Despite this increase in both the prevalence and importance of buyer–supplier relationships, little extant research examines the effect of buyer–supplier relationships on suppliers' financing or investment policy. I contribute to the growing literature about buyer–supplier relationships by providing evidence that firms' cash holdings are affected by the operating risk generated by their engagement in an important relationship. Specifically, I find that suppliers in relationships hold more cash than firms not in relationships, ceteris paribus. And, firms hold more cash during the years that they are in relationships compared to the years when they are not in relationships. Additionally, as the percentage of sales to the major customers and as sales concentration to the major customers increase, so do cash holdings. This result suggests that as relationships induce greater risk firms hold even more cash to offset that risk. These results hold even after controlling for firm profitability, size, leverage, debt capacity, product market position, availability of natural hedges and other firm characteristics. I present additional findings supporting the notion that greater cash holdings are motivated by precautionary measures. Further, the results indicate that increased cash holdings are not the incidental effect of lower leverage. And, firms manage leverage and cash holdings for different purposes. Banerjee et al. (2008) and Kale and Shahrur (2007) find manufacturers of unique goods maintain lower leverage ratios than manufacturers of non-unique goods as a commitment to their buyers. I find that suppliers hold more cash regardless of the type of product manufactured. So, while suppliers maintain low leverage as a commitment to their buyers, they hold cash as a precautionary device to hedge against the risk of adverse cash flow shocks.