The credit multiplier mechanism implies that financially constrained firms face more complementarity between cash <a href=""></a> flow and external funds

As we said above, there is very limited empirical evidence on the role of credit multiplier on the relationship between external financing and cash flow for financially constrained and unconstrained firms. According to Almeida & Campello (2007), financially constrained firms should show more complementarity between the external financing – cash flow relationship because of higher tangible assets. Campello & Hackbarth (2012) used data covering the period 1971–2005 and study the impact of asset tangibility on firms’ investment and financing decisions. They found that compared to financially unconstrained firms, financially constrained firms get more benefits by investing in tangible assets because such assets allow firms to do further investment by relaxing financial constraints.

Gracia & Mira (2014) found that in order to overcome the problem of external financing constraints, financially constrained firms prefer to hold more tangible assets. Almeida & Campello (2010) tested the external financing – cash flow relationship through collateral channel and find that the cash flow coefficient is more positive for financially constrained firms as compared to unconstrained firms. Similar results are also presented by Bernanke et al., (1996) and Kiyotaki & Moore (1997). Their findings also support the macroeconomic literature, showing that more collaterals help relax external financing constraints. Finally, another aspect of tangible assets is their potential to be a direct source of funds. Financially constrained firms, particularly when they confront negative cash flow shocks, can raise funds from sales of tangible asset (see, for example, Borisova & Brown (2013) and Brown & Petersen (2015)).

Data and sample description

To carry out the empirical analysis, we take a large panel of 450 non-financial firms listed at Pakistan Stock Exchange during the sample period. In particular, we create an annual panel dataset covering the period from 2000 to 2013 using the “Balance Sheet Analysis of Non-Financial Firms” published by State Bank of Pakistan (SBP). As the capital structure of financial firms is different from non-financial firms, we exclude them from the sample. To overcome the problem of selection bias we, allow entry and exit of the firms in our dataset. Therefore, our data is an unbalanced panel data.

Models and variables

In order to examine the relationship between external financing and cash flow, we follow Almeida & Campello (2010), Portal et al., (2012), and Gracia & Mira (2014). We consider two different models that enable us to analyze the external financing and cash flow relationship for both financially constrained and unconstrained firms. What follows below we explain both of these models.

External financing-cash flow sensitivity: the role of financial frictions

We consider external funds as a function of internally generated cash flow. Our model also includes firm growth and firm size as control variables. The main focus of the study is to examine the effect of cash flow on the external financing decisions of firms in the presence of financial restrictions. We also take into consideration firm size because large firms can easily substitute between external and internal funds to benefit from economies of scale. Our model also includes growth opportunities, as it is well established in corporate finance literature that growth opportunities have a positive and significant impact on external financing. Therefore, to examine the net effect of cash flow on external financing, we control for the effects of size and growth opportunities. Specifically, the baseline model takes the following form. Footnote 3

where EXTERNAL_FINANCINGi, t is the dependent variable and it shows changes in external financing for ith firm at the time t. Footnote 4 ?i and ?t are firm- and time-specific effects, respectively, and ? i, t is the disturbance term and is used to capture the unobserved shocks in the model.