Cash flow sensitivity of cash: when should we use it to measure financial constraints?

Weiping Hu (), Xiao Zhang () and Ye He ()
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Weiping Hu: Peking University HSBC Business School and PHBS Sargent Institute of Quantitative Economics and Finance
Xiao Zhang: Central University of Finance and Economics
Ye He: Nankai University

Review of Quantitative Finance and Accounting, 2024, vol. 62, issue 2, No 8, 637-682

Abstract: Abstract Since Almeida et al. (J Financ 59:1777–1804, 2004), there has been a long debate on whether the cash flow sensitivity of cash (CFSC) measures financial constraints. Like all measures of financial constraints, CFSC is not a perfect one. Thus, how to measure financial constraints with CFSC effectively is an important issue. This paper shows that when a firm does not save through external financing, the CFSC can be effectively used to measure financial constraints. However, for firms saving from external financing, CFSC does not effectively measure financial constraints, especially when firms use external funds as substitutes for internal ones. The reason is that CFSC does not only reveal the propensity to save from cash flows but also the internal-external financing relation, which is not necessarily linked to financial constraints. Two identification methods are used to confirm our findings.

Keywords: Cash flow sensitivity of cash; Financial constraints; Cash holdings (search for similar items in EconPapers)
JEL-codes: D25 G31 G32 (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1007/s11156-023-01219-3

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