The results indicate that both groups of firms exhibit a negative sensitivity of external financing to cash flow
Empirical findings: baseline model
In order to investigate the external financing – cash flow sensitivity under financial restrictions, we divide the firm-year observations into two groups: financially constrained and unconstrained firms. The fixed effects regression results with robust standard errors are presented in Table 4.
The estimation results reveal that cash flows are negatively related to the external financing decisions of both financially constrained and unconstrained firms. However, the negatively sensitivity of external financing to cash flow is considerably less for constrained firms as compared to their financially unconstrained counterparts. This finding holds for all three-classification criteria we used to classify the firm-year observations. It should also be noted that the estimated coefficient of cash flows appears statistically significant for financially unconstrained firms in case of all classification criteria, whereas, for financially constrained firms, it is only significant when the firms are classified based on the debt to assets ratio. These findings suggest that firms those do not confront any financial hindrance are more likely to reduce external financing in response to increased cash flows. These findings are consistent with the standard pecking order theory of capital structure.
The literature provides several explanations for such findings. First, financially unconstrained firms incur lower cost of external financing relative to financially constrained firms and can easily get the funds from the external capital market whenever they required external financing. Therefore, their external financing is more strongly, negatively related to internally generated funds. Second, since financially constrained firms are expected to face more asymmetric information problem and since the costs of information asymmetry is higher for such firms, they may also decrease their external financing in periods of positive cash flow shocks. Perhaps the firms do so to avoid the higher cost of information asymmetry and give a positive signal to outside investors (Myers (1984) and Myers & Majluf (1984)). However, due to financial market frictions, financially constrained firms are relatively less able to decrease their external financing with increases in cash flows. Finally, as explained by Almeida & Campello (2010), owing to the endogenous nature of investment for the case of financially constrained firms, the sensitivity of external financing to internally generated funds is less as compared to their financially unconstrained counterparts. Our finding on the negative relation between internal cash flow and external funds for financially constrained firms is consistent with the findings of Almeida & Campello (2010), Gracia & Mira (2014), and Portal et al., (2012).
Empirical findings: extended external financing model
Having established the relationship between external financing and cash flow across financially constrained and unconstrained firms, we next estimate the extended external financing model depicted in Eq. (2), which takes into account firms’ pre-existing stock of capital. Following the previous existing studies we estimate this model by applying the GMM estimator to mitigate the problem of possible endogeneity. Table 5 shows the results of the two-step system GMM considering external financing as dependent variable and cash flow, growth, size, cash, inventory, PPE, and debt/equity as independent variables. The estimated values of J-test suggest that the instruments used in the estimation are orthogonal to the residuals. The AR(2) test does not provide any significant evidence of the presence of the second order serial correlation in the residuals. These tests results ensure the validity of the instruments used in the estimations, confirming the reliability of the estimation results.
The results also suggest that the external financing is relatively more sensitive to cash flow shocks for financially unconstrained firms than financially constrained firms for all three financial constrained criteria. The less negative sensitivity of external financing to cash flow implies that financially constrained firms depend more on internally generated funds and are not independent to decide the investment. Hence, investment is endogenous to this category of firms. In contrast, financially unconstrained firms do not substantially depend on internally generated funds and thus, they are free to decide the investment due to less asymmetric information and agency cost problems. Therefore, investment appears exogenous to this type of firms. As a result, both types of firms show negative relationship, yet this relationship is much more intense in case of financially unconstrained firms.