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.
Financial frictions mean financial constraints that prevent corporate firms from funding all desirable investments from external resources. Footnote 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. One of the primary objectives of a firm’s financial policy is to maintain its financial flexibility. An effective financial policy does not only ensure funds for the present but also for the future investments. The value of financial flexibility further increases when financial markets suffer from frictions and financing restrictions compel firms to pass up some profitable investment opportunities due to unavailability of capital (Graham & Harvey (2001)). The previous empirical research on firms’ capital structure decisions also provided evidence that financially constrained firms are expected to get less funds in periods when financing costs are higher (Faulkender & Petersen (2006), Hubbard (1998), Fazzari et al. (1988), and Carpenter & Petersen (2002)).
According to the pecking order theory, asymmetric information costs play an important role in determining the capital structure choice of firms. Therefore, financially unconstrained firms are likely to depend less on internal funds than their financially constrained peers (Myers & Majluf (1984)). Further, owing to information asymmetries, firms prefer debt to equity financing when go for external funds and issue equity only as a last resort. Since information asymmetry increases the external financing cost and since financially constrained firms suffer more from information asymmetries, their external financing should more strongly negatively relate to cash flows. Thus, for a given level of investment, profitable financially constrained firms require less external capital to finance their investments, and therefore, they are less likely to tap the external capital markets. However, 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. These studies have explained that information asymmetries have an important role to play in deciding the capital structure of corporate firms. Doing empirical analysis for developed countries, they have provided strong evidence on the negative association between cash flows and external financing. Yet, they show that this negative relationship is relatively stronger for financially constrained firms. The more negative and statistically significant relationship between internal funds and external financing for financially constrained firms implies that financially constrained firms’ investing decisions are determined endogenously and strongly depend on internally generated funds. On the other hand, the investment decisions of financially unconstrained firms might be mainly determined exogenously, showing no significant dependence on cash flows.