Assessing the Relationship between Financial Slack and Company Performance during an Economic Recession: An Empirical Study

Research on whether financial slack helps or hinders the performance of the firm remains equivocal. One school of thought maintains that slack provides a degree of insulation from environmental change; the second school of thought suggests that slack desensitizes managers to environmental changes. Our study engaged the debate during an economic recession. We examined the effect of slack on performance in 450 software firms during the 2001-2003 economic downturn and recovery. Our measurement of slack specifically focused on available slack, which we gauged using the firm's current ratio. The analysis revealed that organizations with more available slack demonstrated a more rapid rate of performance decline in the initial stages of the recession, but later in the recession they demonstrated a quicker rate of performance recovery. Introduction Does organizational slack grant flexibility for firms to swiftly adjust to environmental shifts? Or does its presence indicate managerial inefficiencies that hamper strategic adaptation? The preceding dichotomy on the role of slack in managing organizations represents one of the more salient intersections between business policy research and managerial practice. Since organizational slack is viewed to be at management's discretion, scholars have focused on the extent to which slack resources should be governed to benefit the firm. One school of thought suggests that slack represents a valuable asset, especially in the context of environmental change. However, other scholars have argued that firms with too much slack are likely to be rife with deficiencies to begin with, and thus ill-suited to weather environmental change. This paper examines these divergent views of organizational slack within the specific context of an economic recession. Because recessions represent one of the most significant environmental threats to an organization's viability and continued profitability (Pearce and Michael 2006), a firm's effective management of slack resources may be particularly amplified within this unique context. That is, as sales revenues decline, profit margins decrease, and available financing dries up, a firm's slack, according to one line of reasoning, may become increasingly scarce and thus critically valuable. While this view aligns with Cheng and Kesner's (1997) assertion that slack may mitigate the effect of economic recessions, it has yet to receive empirical confirmation. This paper aims to offer managerial guidance as well as a contingency approach on the potential influence of certain circumstances on the nature of the slack-performance relationship. As such, we extend previous work on the role of financial slack in firms by offering an empirical examination of the relationship between financial slack and firm performance under circumstances of environmental duress. If slack provides concrete benefits in its ability to buffer firms from environmental disruptions, as many scholars have suggested, then we would witness firms with more slack resources outperforming those with fewer slack resources over the course of a recession. Conversely, if the availability of slack, already representative of managerial ineptitude, desensitizes firms from recession-related demand shocks, then we might expect them to under perform their low-slack counterparts. In undertaking this study, we address recent sentiments by Pearce and Michael (2006) that few managerial prescriptions exist for successfully navigating recessions. This paper provides insights for managers on how to favorably position their firm to survive an economic recession. Slack, Economic Recession, and Performance For the purpose of this paper, we define slack as available resources that remain uncommitted to system operations, such as cash or available credit lines. In general, scholars have identified a multitude of benefits of firm slack in growing the organization. For one, slack alleviates goal conflict within the firm by providing necessary means to solve resource problems (Cyert and March 1963). …