No. 228 The Effect of Cash Flow on Investment: An Empirical Test of the Balance Sheet Channel

by Ola Melander, Maria Sandström and Erik von Schedvin

April 2009 (Updated March, 2016)

Abstract

Using a large data set on investments and accounting information for private firms, we put the balance sheet theory to test. We find that firm cash flow has a positive impact on investment and that the effect is enhanced for firms which are more likely to be financially constrained. We also find that the investment-cash flow sensitivity is significantly larger and more persistent during the first half of our sample period, which includes a severe banking crisis and recession. Our results suggest that financial constraints matter more in periods characterized by adverse economic conditions.

Keywords

Financial frictions, balance sheet channel, financial accelerator, investment, cash flow.

JEL codes

C33, E22, E44.