Financial Distress of Companies and Cash Flow-Investment-Sensitivity: Evidence From Panel of Non-Financial Firms

Abstract

This paper aims to investigate the effects of cash flow-investment sensitivity over firms facing varying levels of financial distress. For this purpose, cash flow, dividend policy, firm's age, and size are used to create subsamples of firms facing different degrees of financial constraints. Using an unbalanced panel of 336 non-financial firms listed at Pakistan Stock Exchange over the period from 2006 to 2017, we provide evidence that the prevailing financial constraints affect the investment decisions of sample firms. Financial distress, as identified by cash flow, dividend policy and size of the firm, increases with the rise of cash flow-investment-sensitivity, thus substantiating the use of these measures as indicators of financial distress. Furthermore, evidence of the U-shaped investment curve is found when the sample is split on the basis of cash flow, suggesting a non-linear relation between cash flow and investment. The results shed light on the relation between financial and real cycle downturns suggesting the need for economic policies to be countercyclical with respect to financial and credit conditions.