The Cash Flow Sensitivity of Cash

Abstract

We use the link between financial constraints and a firm's demand for liquidity to develop a new test of the effect of financial constraints on firm policies. The effect of financial constraints can be captured by a firm's propensity to save out of incremental inflows (the cash flow sensitivity of cash). While constrained firms should have a positive flow sensitivity of cash, unconstrained firms' savings should not be systematically related to flows. We estimate the flow sensitivity of using a large sample of manufacturing firms over the 1971-2000 period and find that firms that are more likely to be financially constrained display a significantly positive flow sensitivity of cash, while unconstrained firms do not. Also consistent with our argument, we find that constrained firms' flow sensitivity of increases during recessions, while unconstrained firms' cash--cash flow sensitivity is unaffected by macroeconomic innovations. The use of flow sensitivities of appears to be a theoretically justified, empirically useful method to test for the importance of financial constraints.