Effect of Earnings Volatility on Cost of Debt: The case of Swedish Limited Companies
The paper empirically tests the relationship between earnings volatility and cost of
debt with a sample of more than 77,000 Swedish limited companies over the period 2006 to
2013 observing more than 677,000 firm years. As called upon by many researchers recently
that there is very limited evidence of the association between earnings volatility and cost of
debt this paper contributes greatly to the existing literature of earnings quality and debt
contracts, especially on the consequence of earnings quality in the debt market. Earnings
volatility is a proxy used for earnings quality while cost of debt is a component of debt
After controlling for firms’ profitability, liquidity, solvency, cashflow volatility,
accruals volatility, sales volatility, business risk, financial risk and size this paper studies the
effect of earnings volatility measured by standard deviation of Earnings Before Interest,
Taxes, Depreciation and Amortization (EBITDA) on Cost of Debt.
Overall finding suggests that lenders in Sweden does take earnings volatility into
consideration while determining cost of debt for borrowers. But a deeper analysis of various
industries suggest earnings volatility is not consistently used by lenders across all the
industries. Lenders in Sweden are rather more sensitive to borrowers’ financial risk across all
the industries. It may also be stated that larger borrowers tend to secure loans at a lower
interest rate, the results are consistent with majority of the industries. Swedish debt market
appears to be well prepared for financial crises as the debt crisis seems to have no or little
adverse effect borrowers’ cost of capital.
This study is the only empirical evidence to study the association between earnings
volatility and cost of debt. Prior indirect research suggests earnings volatility has a negative
effect on cost debt (i.e. an increase in earnings volatility will increase firm’s cost of debt).
Our direct evidence from the Swedish debt market is consistent for some industries including
media, real estate activities, transportation & warehousing, and other consumer services.
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