Financing patterns of working capital and physical investment: their effects on innovation and productivity

Abstract

ABSTRACT Firms must access financial markets to surpass financial barriers limiting innovation activities. However, an overreliance on debt might moderate creativity and innovativeness. From a sample of European manufacturing firms, and applying a system of equations using GSEM, we derive a function to determine the thresholds of the optimal acquisition of working capital and physical investment. Contrasting this information with the descriptive data, firms tend to under-finance working capital, as future short-term needs are more challenging to identify when designing investment plans. Additionally, we find evidence for the heterogeneous financial needs of firms operating in high-tech as compared to low-tech sectors, as well as other differences related to firm age. Overall, this paper demonstrates the existence of an optimal proportion of working capital and physical investment that maximizes innovation activities and firm performance, deriving diminishing returns from debt financing and the complementarities between short-term and long-term financial needs.