Paper Example on Supporting the Use of Cash Flow Sensitivity

Cash flow sensitivity entails the reaction of a firm to the variations that take place in regards to the external and internal liquidity. Managers in various firms try to actively counteract the changes through the accumulation of the working capital at the time the liquidity goes up and consequently draining it when the liquidity drops. As a result of this movement, cash flow-sensitive organizations encounter financial constraints. Closely monitoring the cash flow sensitivity about change in the capital structure is vital for any organization. This explains why various proponents have been put forward to support the usage of cash flow sensitivity.

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According to Fazzari, Hubbard & Petersen (1988), cash flow sensitivity is paramount in the determination of investing and the spending level within the corporate world. According to this literature firms which tend to be financially constrained tend to display higher sensitivity level when it comes to investment, and this is linked to how the internal finance which is proxied by the cash flows are available. The studies highlight that firms which face high financial constraint tend to have higher investment-cash flow sensitivity as compared to those firms whose financial constraint levels are low. Private finance, which is crucial to the capital structure, tends to influence the investment level within the organization hence the reason why internal funding is viewed as having essential cost advantages compared to the external finance. Through cash flow sensitivity analysis, investors are placed in a better position to analyze various firms' ability to access finance externally. Firms constrained in their ability to raise external funding makes the investment to be more sensitive to only the existence of the internal fund. To this extent, cash flow sensitivity is crucial in determining the spending and investment levels and indicating how a firm is constrained financially.

Almeida, Campello, and Weisbach (2011) analyze the effects of cash flow sensitivity of cash and the results the financial constraints have on the various corporate policies. The literature analyses how financially strained firms or healthy firms are anticipating some level of financial restraint in the future react to such potential obstacles through hoarding of cash today. Firms, therefore, through the cash flow sensitivity adjust their various policies in anticipation of future constraints. Possibility of future restrictions leads to the various firms to prefer those investments which have payback periods which are shorter, less risky investments and those which utilizes assets that are more liquid. Additionally, the research highlights firms tend to have incentives meant to reduce the risks rather than increasing it when the firm's leverage rises. Going by the research, firms that are constrained will tend to distort risk profile related to the projects which are more liquid, rather than those of illiquid projects. This is so because illiquid projects display lower impact towards the future capacity to finance various projects. Finally, the literature highlights how firms will also distort the investment policies for those projects that bring about cash flows that are verifiable when they encounter finance constraints. As demonstrated clearly by the research, cash flow sensitivity remains vital in making both short and long term decisions.

Kumar and Ranjani (2018) analyze the financial constraints and various investments decisions involving manufacturing firms which are listed. The analysis focusses on the role the tangibility plays in the alleviation of financial constraints and the role played by other financial factors in making various investment decisions. Upon the completion of the analysis, it was found that cash flow sensitivity plays a critical part in the financial constraint measurement among the manufacturing sector of India. The results indicate that the investment decisions of the firms that stand alone are highly sensitive to cash flow compared to the affiliated firms which are grouped. Further, the study indicates that when the firms are divided according to their tangible net worth and their market capitalization, a higher degree regarding cash flow sensitivity is witnessed among the firms that have lower asset tangibility and market capitalization. The impact of assets tangibility when it comes to easing the financial constraints appeared to be more significant among firms that have a tangible net worth that is low and with a market capitalization that is medium. The study, therefore, affirms that cash flow sensitivity is indeed a measure of financial constraints and it confirms how financial firms that are constrained pool their internal funds in order to accept investment opportunities that are profitable in future.

Cash flow sensitivity analysis plays an instrumental role in determining the capital structure of the organization. Investors and shareholders are aided by the cash flow sensitivity; hence, they can quickly know when the firm is strained financially or not. Through this, the shareholders can decide to inject in more funds into the organization or pay out dividends. The sensitivity guides the organization on the right moment to pay dividends or inject new funds by the shareholders. On the other hand, investors look at the sensitivity to gauge the future stability of their investments. The main aim of the capital structure is mainly to maximize the gains that go to the shareholders by maximizing the stock prices and minimizing the cost of capital hence the balance between the return and the associated risks. The higher the cash flow sensitivity to the capital structure, the higher the attention made by the shareholders in a bid to streamline the operations to caution the organizations against further uncertainties (Lamont, 1997).

Cash flow sensitivity can also be linked to financial systems. Market-oriented systems tend to show a higher level of sensitivity to cash flow while the relationship-oriented policies foster arrangements that are more transparent which allow them to exercise a higher level of scrutiny over the borrowers which will, in turn, make the investors less sensitive towards the various sources of funds internally. Markets systems tend to be different, and this can be seen in the difference between their cash flow sensitivity to investment (Rajan, & Zingales, 2003).

Gertler and Gilchrist (1994) bring out the relationship that exists between cash flow sensitivity and the firm's size. Smaller firms portray a high level of specific risks and with fewer collaterals, which in turn make them face challenges when it comes to attracting external finance, making them be more financially strained. The smaller the firm, the more it is sensitive to the various monetary policies tightening as compared to the large firms. Through cash flow sensitivity, it is therefore clear to bring out the size of the firm and their ability to compete with others in the market (Bernanke, Gertler & Gilchrist, 1994).

In conclusion, cash flow sensitivity plays a vital role among various firms as supported by multiple scholars. More considerable attention should, therefore, be made when it comes to cash flow sensitivity as it indicates when a firm if financially strained or not. There are further benefits that justify the greater need to utilize cash flow sensitivity as a measure of financial constraint.

References

Almeida, H., Campello, M., & Weisbach, M. S. (2011). Corporate finance and investment policies when future financing is not frictionless. Journal of Corporate Finance, 17(3), 675-693. Retrieved from https://www.sciencedirect.com/science/article/pii/S0929119909000376

Bernanke, B., Gertler, M., & Gilchrist, S. (1994). The financial accelerator and the flight to quality (No. w4789). National Bureau of Economic Research. Retrieved from https://www.nber.org/papers/w4789

Fazzari, S., Hubbard, R.G. and Petersen, B. (1988) Financing Constraints and Corporate Investment. Brookings Papers on Economic Activity, 1, 141-195. http://dx.doi.org/10.2307/2534426

Kumar, S., & Ranjani, K. S. (2018). Financial constraints and investment decisions of listed Indian manufacturing firms. Financial Innovation, 4(1), 6. Retrieved from https://jfin-swufe.springeropen.com/articles/10.1186/s40854-018-0090-4

Lamont, O. (1997). Cash flow and investment: Evidence from internal capital markets. The Journal of Finance, 52(1), 83-109. Received from https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1997.tb03809.x

Rajan, R. G., & Zingales, L. (2003). The significant reversals: the politics of financial development in the twentieth century. Journal of financial economics, 69(1), 5-50. Retrieved from https://www.sciencedirect.com/science/article/pii/S0304405X03001259