The Cash Flow Sensitivity of Cash

We model a firm’s demand for liquidity to develop a new test of the effect of financial constraints on corporate policies. The effect of financial constraints is captured by the firm’s propensity to save cash out of cash flows (the cash flow sensitivity of cash). We hypothesize that constrained firms should have a positive cash flow sensitivity of cash, while unconstrained firms’ cash savings should not be systematically related to cash flows. We empirically estimate the cash flow sensitivity of cash using a large sample of manufacturing firms over the 1971 to 2000 period and find robust support for our theory. TWO IMPORTANT AREAS OF RESEARCH in corporate finance are the effects of financial constraints on firm behavior and the manner in which firms perform financial management. These two issues, although often studied separately, are fundamentally linked. As originally proposed by Keynes (1936), a major advantage of a liquid balance sheet is that it allows firms to undertake valuable projects when they arise. However, Keynes also argued that the importance of balance sheet liquidity is influenced by the extent to which firms have access to external capital markets (p. 196). If a firm has unrestricted access to external capital— that is, if a firm is financially unconstrained—there is no need to safeguard against future investment needs and corporate liquidity becomes irrelevant. In contrast, when the firm faces financing frictions, liquidity management may become a key issue for corporate policy. Despite the link between financial constraints and corporate liquidity demand, the literature that examines the effects of financial constraints on firm behavior has traditionally focused on corporate investment demand. 1 In an influential paper, Fazzari, Hubbard, and Petersen (1988) propose that when firms face financing constraints, investment spending will vary with the availability of internal funds, rather than just with the availability of positive net present