Abstract
This paper uses a large panel of Pakistani non-financial firms over the period 2000–2013 to examine the role of financial constraints in establishing the relationship between cash flow and external financing. The results reveal that there exists a negative and significant relationship between external financing and cash flow. The finding of the substitutionary relation between internal funds availability and external financing has been viewed as evidence supporting the pecking order theory of capital structure. Yet, we show that this negative relationship is weak in case of financially constrained firms. We also analyze how credit multiplier affects external financing decisions of financially constrained and unconstrained firms. The results show that for financially unconstrained firms, the negative sensitively of external financing increases with asset tangibility. However, for financially constrained firms, the negative sensitivity of external financing to cash flow either decreases or turns positive as the tangibility of assets increases. This finding implies that financially constrained firms benefit more from investing in tangible assets because such assets not only help relax financial constraints but also having a potential to be a direct source of funds in periods of negative cash flow shocks.
Highlights
Financial frictions mean financial constraints that prevent corporate firms from funding all desirable investments from external resources.1 This financing incapability might be due to either the inability or the reluctance of firms to issue new equity and debt instruments, the inability of firms to borrow from financial intermediaries, the greater dependence of firms on bank loans, the prevalence of credit constraints, or the illiquidity of firms’ assets
We find a significant negative relationship between cash flow and external financing
We find that the negative sensitivity of external financing to cash flow is higher for financially unconstrained firms as compared to their financially constrained counterparts
Summary
Financial frictions mean financial constraints that prevent corporate firms from funding all desirable investments from external resources. This financing incapability might be due to either the inability or the reluctance of firms to issue new equity and debt instruments, the inability of firms to borrow from financial intermediaries, the greater dependence of firms on bank loans, the prevalence of credit constraints, or the illiquidity of firms’ assets. One should note that this argument assumes that a firm determines its level of investment before determining the optimal amount of debt and equity to issue (Myers (1984)) Several recent studies such as Almeida & Campello (2010) and Gracia & Mira (2014) have documented strong evidence on the role of financial frictions in determining the relationship between internally generated funds (cash flows) and the funds obtained from the external capital markets. Firms operating in Pakistan face higher credit constraints, suffer more from information asymmetries, and pay more costs for external funds and have to provide more collaterals to seek funds from external capital markets In this context, the role of financial frictions and the credit multiplier in establishing the linkages between cash flows and external financing would be worth exploring.
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