Do Credit Rating Agencies Value Less Volatile Leverage

Prior studies investigating financial statement volatility focus primarily on the volatility of income statement items, earnings volatility in particular, while our knowledge of the effects of the volatility of balance sheet items remains limited. We focus on leverage, arguably the most important balance sheet item ratio, and we investigate how credit rating agencies assess firms with smoother leverage ratios. We document that after controlling for a variety of firm characteristics, including the level of leverage and free cash flow, credit ratings are negatively related to leverage volatility. These results suggest that one benefit for firms with lower leverage volatility is a more favorable credit rating. We also examine the characteristics of firms with a greater ability to smooth leverage ratios. We find a negative relation between financial reporting quality and leverage volatility, consistent with the idea that higher financial reporting quality provides firms with better access to both equity and debt financing, providing greater flexibility to smooth leverage than firms with lower financial reporting quality.