Working Paper no. 112
By Ian Small
This paper uses a panel of UK manufacturing firms to examine whether the effect of cash flow on inventory investment reflects the presence of financially constrained firms. Financially constrained firms are identified using a number of criteria, including the criterion suggested by Bond and Meghir (1994) based on the firm’s financial policy. The main finding is that the effect of cash flow on inventory investment is concentrated among firms identified as financially constrained using either their financial policy or a criterion based on their current ratio. This suggests that there is no unique criterion for identifying financially constrained firms using financial information in company accounts. Contrary to what previous studies have found, using firm size or the coverage ratio to define financially constrained firms does not reduce the effect of cash flow on the inventory investment of unconstrained firms. This raises doubts about whether these are accurate indicators of whether a firm is financially constrained. Combined with Bond and Meghir’s similar findings for fixed investment, the results in this paper suggest that cash flow effects form part of the monetary transmission mechanism.