Inventory Investment and Cash Flow

The Bank of England Working Paper No. 112

30 Pages Posted: 16 Oct 2000

Date Written: 2000

Abstract

This paper uses a panel of UK manufacturing firms to examine whether the effect of cash flow on inventory investment reflects the presence of financially constrained firms. Financially constrained firms are identified using a number of criteria, including the criterion suggested by Bond and Meghir (1994) based on the firm's financial policy. The main finding is that the effect of cash flow on inventory investment is concentrated among firms identified as financially constrained using either their financial policy or a criterion based on their current ratio. This suggests that there is no unique criterion for identifying financially constrained firms using financial information in company accounts. Contrary to what previous studies have found, using firm size or the coverage ratio to define financially constrained firms does not reduce the effect of cash flow on the inventory investment of unconstrained firms. This raises doubts about whether these are accurate indicators of whether a firm is financially constrained. Combined with Bond and Meghir's similar findings for fixed investment, the results in this paper suggest that cash flow effects form part of the monetary transmission mechanism.

JEL Classification: E22, E52

Suggested Citation

Small, Ian, Inventory Investment and Cash Flow (2000). The Bank of England Working Paper No. 112. Available at SSRN: https://ssrn.com/abstract=230783 or http://dx.doi.org/10.2139/ssrn.230783

Ian Small (Contact Author)

Lexecon Ltd.

Orion House
5 Upper St Martin's Lane
London WC2H 9EA
United Kingdom

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