Differential effect of liquidity constraints on firm growth

• Author: Syed Manzur Quader
• Date: 01 January 2017
• Published date: 01 January 2017
• DOI: http://doi.org/10.1016/j.rfe.2016.09.004

Review of Financial Economics 32 (2017) 20–29

Contents lists available at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe

Differential effect of liquidity constraints on firm growth

Syed Manzur Quader

Independent Business School, Chittagong Independent University, 16, Jamal Khan, Chittagong, Bangladesh

ARTICLE INFO

Article history:

Received 4 February 2016

Received in revised form 15 September 2016

Accepted 20 September 2016

Available online 26 September 2016

JEL classification:

C23

D82

G32

L25

Keywords:

Law of proportionate effects

Financial constraints

Growth cash flow sensitivity

Leverage effect

GMM

ABSTRACT

Differential quantitative effects of internal finance on growth among firms facing different degrees of finan-

cial constraints are found in this paper using an unbalanced panel data on 1122 UK firms listed on the

London Stock Exchange. The generalized methods of moments (GMM) estimation results are consistent with

financial constraints arising from capital market imperfections and indicate a substantially greater sensitiv-

ity of growth to cash flow for firm years facing the most binding financial constraints. Furthermore, these

firms can actually expand their size more than the extent of increase in cash flow they may have which sup-

ports the leverage effect hypothesis. The estimated impact decreases monotonically thereafter as financial

constraints become less binding allowing the firms to finance successively bigger portion of their growth

through external financing.

© 2016 Elsevier Inc. All rights reserved.

1. Introduction

Building on the idea that internal and external finance becomes

imperfect substitute of each other under the presence of market

imperfections, most of the theoretical and empirical studies inves-

tigate the effect of financing constraints on firms’ investment deci-

sions. However, the effects of financial constraints on firm growth

can be quantitatively important as well. This is because if the prob-

lems of market imperfection restrict firms’ access to lower cost

external financing, then such firms may not be successful in pur-

suing their optimal investment policy and may suffer from lower

growth rates in the future (Fazzari, Hubbard, Petersen, Blinder, &

Poterba, 1988, Devereux & Schiantarelli, 1990). There may also be

some discernible factors which shape the growth pattern of firms

with different credit status as well. A growing literature in indus-

trial economics also postulates that firm size and age are likely to

affect firm growth dynamics through two different and inversely

directed channels. One of them is that smaller and younger firms are

more likely to be at an earlier stage in their development or firm

life cycle which can possibly facilitate them to grow faster until they

reach some critical or sustainable size. On the contrary, smaller and

E-mail address: manzur@ciu.edu.bd.

younger firms are characterized by idiosyncratic risk, less collateral,

insufficient track record and weak socioeconomic networks which

raise the cost of external capital and limit their access to exter-

nal financing. Audretsch and Elston (2006) name the first one as

“other” and the latter one as “financial-related” size effects and rec-

ommend decomposing them to better understand the differences

in the dynamics of the size–growth relationship between smaller

younger firms and their matured counterparts. Therefore, to eval-

uate the effects of financial constraints on firm growth, any causal

growth regression must be conditioned on firm size, age and produc-

tivity differences as well. The productivity differences and financial

risk of firms emanated from their economic performances and finan-

cial structures respectively are likely to drive firm heterogeneity,

which needs to be controlled for to make the results unbiased and

consistent.

Contemporary literature has followed both stochastic and deter-

ministic approaches to analyze the main factors affecting firm growth

and financing opportunities. With respect to the former, empirical

studies start with Gibrat (1931) “law of proportionate effects” (LPEs)

as an empirical benchmark, which states that the growth rate of any

firm is independent of its size at the beginning of the period exam-

ined and that the firm size distribution (FSD) is stable over time and

approximately log normal. A large body of empirical studies challenge

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