The Cash Flow Sensitivity of Cash

Abstract

We use the link between financial constraints and a firm's demand for liquidity to develop a new test of the effect of financial constraints on firm policies. The effect of financial constraints can be captured by a firm's propensity to save cash out of incremental cash inflows (the "cash flow sensitivity of cash"). While constrained firms should have a positive cash flow sensitivity of cash, unconstrained firms' cash savings should not be systematically related to cash flows. We estimate the cash flow sensitivity of cash using a large sample of manufacturing firms over the 1971-2000 period and find that firms that are more likely to be financially constrained display a significantly positive cash flow sensitivity of cash, while unconstrained firms do not. Also consistent with our argument, we find that constrained firms' cash flow sensitivity of cash increases during recessions, while unconstrained firms' cash--cash flow sensitivity is unaffected by macroeconomic innovations. The use of cash flow sensitivities of cash appears to be a theoretically justified, empirically useful method to test for the importance of financial constraints.

Keywords: Cash flow sensitivity of cash, financial constraints, cash policy, macroeconomic innovations

JEL Classification: G31, G32, D23, D92