Previous empirical research on the link between cash flows and external financing is scant

Previous empirical research on the link between cash flows and external financing is scant

There is also an intense debate on the role of credit multiplier in establishing the external financing – cash flows relationship

The credit multiplier is considered as an additional instrument, which makes the relationship between cash flows and external funds less negative. Financially constrained firms suffer more from adverse selection costs than the financially unconstrained firms do. Therefore, creditors require more loan guarantees, mainly in terms of pledging tangible assets, in order to save their contracts while lending to financially constrained firms. Thus, financially constrained firms are likely to invest excess of their internal funds in tangible assets such as plant, property, and equipment. Possession of more tangible assets makes easy for financially constrained firms to acquire external funds. Several previous studies including Campello & Hackbarth (2012), Almeida & Campello (2007), Bernanke et al. (1996), and Kiyotaki & Moore (1997) have suggested that the tangibility of assets increases the capability of financially constrained firms to seek new funds. Almeida & Campello (2007) provided evidence that firms increase their tangible assets when they are in periods of positive income shocks which in turn increase firms’ capacity for new credit and as a result more tangible assets and so on. Almeida & Campello (2010) and Gracia & Mira (2014) demonstrated that financially constrained firms are more sensitive to increase the holdings of tangible assets. Therefore, the credit multiplier effect is expected to be more prominent in case of financially constrained firms than for unconstrained firms.

Furthermore, such market conditions are expected to have a significant impact on the relationship between cash flow and firms’ external financing decisions

The most of the previous existing studies such as Almeida & Campello (2010), Gracia & Mira (2014), and Schoubben & Van Hulle (2011) have explored the issue for developed countries only. However, when we review the literature for developing countries, we observe that researchers have not paid considerable attention on the external financing-cash flows relationship. Rather, most of the previous studies in emerging and developing countries have focused on exploring the capital structure determinants. With reference to Pakistan, the literature is also silent on the issue how firms’ make external financing decisions when they face financial constrains. Yet, in developing countries, like Pakistan, firms probably face higher financial constrains, as financial markets in these countries are more likely to experience the financial frictions. The prevalence of financial market frictions due to under developed financial system and capital market and unfavorable banking sector policies for corporate firms significantly increase adjustment costs, which, in turn, considerably affect the external financing choices of firms. Therefore, to get a complete understanding of how financial constrains affect the substitution between internal and external funds, it would be worthwhile to get empirical evidence on this issue from emerging and developing countries.

Another gap in the literature is that there is little empirical evidence on the role of credit multiplier in external financing decision for developing countries. However, there are numerous studies in developed countries regarding the role of credit multiplier effect on the external financing-cash flow relationship (Almeida & Campello (2007), Bernanke et al. (1996), and Kiyotaki & Moore (1997)). These studies concluded that in case of financially constrained firms, credit multiplier plays an important role in getting new external funds. In developing countries, there are more financial frictions and uncertainty and therefore, creditors require more securities/collateral for their loans. In this context, empirical evidence on the impact of credit multiplier for emerging and developing countries would really help firm managers to understand the role of tangible assets in mitigating the impact of financial constraints.

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