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Rashid, A., Jabeen, N. Financial frictions and the cash flow – external financing sensitivity: evidence from a panel of Pakistani firms. Financ In).

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Although information asymmetry is expected to play a significant role in formulating the linkages between internal funds and external financing, it is not the whole story. As stated by Almeida & Campello (2010), financially constrained firms are more reliant on internally generated funds while making investment decisions. On the flip side, financially unconstrained firms are generally free to make decisions regarding investment. Said differently, investment is exogenous for unconstrained firms. Thus, Almeida and Campello stated that in case of financially constrained firms, the endogeneity of investment is the fundamental cause for the negative sensitivity of external funds to cash flows. However, it should be noted that the standard pecking order theory of capital structure does not take into account any possibility that firm investment may become endogenous when firms face credit constraints.

Pakistan provides a good setting for testing these both issues. In Pakistan, financial markets suffer highly from financial frictions, as economic, financial, and political uncertainty is showing a hiking trend due to energy crisis, political unrest, and ongoing long lasting fight against terrorism. Given all these, firms operating in Pakistan not only face higher credit constraints, suffer more from information asymmetries, and pay more costs for external funds but also have to provide more collaterals to seek funds from external capital markets. In this context, the role of financial frictions and the credit multiplier in establishing the linkages between cash flows and external financing would be worth exploring.

Brown & Petersen (2009) argued and empirically shown that the decline or disappearance of investment-cash flow sensitivity is partly because of a shifting priority (at least among U.S. firms) from investing in fixed capital to investing in R&D and cash reserves. Footnote 2 Similarly, Chen & Chen (2012) also recorded a significant decline in the sensitivity of investment to cash during the credit crunch of 2007–2009. If this is indeed the case, then one ination of the external finance-cash flow relationship might be a better way to study financing frictions in modern firms.

We extend the baseline model presented in Eq. (1) by taking into consideration firms’ previous internal financing and their internal liquidity level (extended model henceforth). Following earlier researches including Fazzari & Petersen (1993), Almeida et al., (2004), Almeida & Campello (2010), and Rajan & Zingales (1995), we control already available stock of internal funds and other working capital to avoid the cash flow shocks. Specifically, the extended model takes the following form:

Estimation technique

The coefficient of cash flow indicates that there is a negative and statistically significant relationship between external financing and cash flows. The estimated value of the coefficient suggests that for each Pak rupee of internally generated cash flow shortfall, firms get about 9.4% in new external financing. The negative relationship is consistent with the prediction of the pecking order theory. This finding is also consistent with the findings of Fama & hop over to the web site French (2002), Leary & Roberts (2005), and Almeida & Campello (2010). The coefficient of growth suggests that the relationship between growth and external fund is positive and statistically significant. This result indicates that growing firms are more likely to raise funds from external sources. The positive relationship between firm growth and external funds is in agreement with the findings of Lemmon & Zender (2010), Gracia & Mira (2014), and Carpenter & Petersen (2002). Finally, consistent with the trade-off theory, the estimated coefficient of firm size indicates that large-sized firms do more external financing. This finding is also confirmed by Fama & French (2002), Titman & Wessels (1988), and Hovakimian (2011). These results suggest that on average, the external financing decisions of firms operating in Pakistan are not only consistent with the capital structure theories but are also similar to the firms operation in developed countries like the UK and the USA.

Measuring the impact of credit multiplier on firms’ external financing decision

Our results suggest that when constrained firms face shocks, they tend to reduce less amount of external financing as compared to financially unconstrained firms. Presumable, under financial frictions, information asymmetries are not the core of the decision. As an alternative, what is important and accountable for this decision is the endogeneity of investment for financially constrained firms because they are facing financial frictions while seeking external funds. These results also suggest that the pecking order has a significant impact on the capital structure decisions of firms.