However, they suggested that although the investment of publicly listed companies is exogenously determined, they are likely to reduce leverage by using excess cash flow
They show that the tangibility of assets strengthens the relationship between investment and cash flow for capital-constrained firms. They also state that financing restrictions have a significant impact on the investment choices of corporate firms.
Several other studies have also examined the relationship between the profitability of firms and the debt to equity ratio. For example, Rajan & Zingales (1995) using a panel of US listed firms found that the relationship between firm profitability and the debt to equity ratio is negative. Lemmon & Zender (2010) concluded that some of the patterns observed in the capital structure decisions of firms are highly consistent with the pecking order theory. Shyam-Sunder and Myers (1999) using a sample of 157 US firms documented that most of the firms use debt financing to finance their financing deficits. Fama & French (2002) and Myers (1977) also supported the pecking order theory and conclude that firms first prefer internal cash flow and then use the external funds. Brav (2009) examined the financial behavior of UK private and public firms and find that private firms, which are generally considered financially constrained firms, have less financial flexibility because they experience more information asymmetry as compared to publicly listed firms. Caglayan & Rashid (2014) using a larger panel of public and nonpublic/private UK manufacturing firms documented that compared to publicly listed firms, the leverage decisions of nonpublic firms are more affected by firm-specific risk. Arslan-Ayaydin, Florackis, & Ozkan (2014) doing empirical analysis for a large set of East Asian firms over the period 1994–2009 found that firms that are financially flexible prior to the financial crisis of 2007–2008 are more capable to do investment and do not highly rely on the availability of internal funds to invest.
Another study by Kim (2014) using the data covering the period 1990–2008 provided evidence that compared to capital-unconstrained firms, financially unconstrained firms have higher sensitivity of investment to cash flow
The presence of the negative external financing – cash flow relationship seems inconsistent with the prediction of the trade-off theory of capital structure. According to the trade-off theory, more profitable firms used more external financing (debt) because to harvest the benefits of debt tax shield. If tax benefits are more attractive, then firms prefer debt financing instead of utilizing internal funds. Graham (2000) found that firms could get benefit from the taxes until the cost associated with taxes are less than the bankruptcy cost. Therefore, large and higher profitable firms used debt conservatively. The recent literature suggests that the relationship between internal and external financing is negative because of adjustment costs. For example, Strebulaev (2007) found a negative and significant relationship between firm profitability and leverage for only those firms that are not able to readjust their capital structure.
Almeida & Campello (2010) working on the panel data of US firms covering the period of more than 30 years examined the role of financial frictions in establishing the relationship between cash flow and external funds. They used four different firm characteristics to identify financially constrained and unconstrained firms. They found a negative and statistically significant external financing – cash flow relationship for financially unconstrained firms. One the other hand, in case of financially constrained firms, they found that external financing is less negatively or statistically insignificantly related to internal funds. They suggested that due to the endogenous nature of investment, there exists a complementarity between the internally generated funds and external financing for financially constrained firms.
Gracia & Mira (2014) using a large panel of Spanish firms explored the relationship between external funds and internally generated funds instant pay day loan for financially constrained and unconstrained firms. They found that for both types of firms, the relationship between external financing and internal funds is negative. Yet, for financially constrained firms, this relationship is less negative. They argued that for unlisted firms, investment is endogenously determined and thus, these firms are strongly depended on the internal funds while making investing decisions.