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Financial Development and the Cash Flow Sensitivity of Cash

Published online by Cambridge University Press:  06 April 2009

Inder K. Khurana
Affiliation:, School of Accountancy, College of Business, University of Missouri-Columbia, Columbia, MO 65211.
Xiumin Martin
Affiliation:, School of Accountancy, College of Business, University of Missouri-Columbia, Columbia, MO 65211.
Raynolde Pereira
Affiliation:, School of Accountancy, College of Business, University of Missouri-Columbia, Columbia, MO 65211.


Prior research posits that market imperfections and the lack of institutions that protect investor interests create a divergence between the cost of internal and external funds, thereby constraining firms' ability to fund investment projects through external financing. Financial constraints force firms to manage their cash flows to finance potentially profitable projects. A related stream of research documents that financial constraints due to costly external financing are more pronounced in underdeveloped financial markets. We examine the influence of financial development on the demand for liquidity by focusing on how financial development affects the sensitivity of firms' cash holdings to their cash flows. Using firm-level data for 35 countries covering about 12,782 firms for the years 1994–2002, we find the sensitivity of cash holdings to cash flows decreases with financial development. We also consider additional implications of firms' cash flow sensitivity of cash with respect to firm size and business cycles. Overall, we provide new cross-country evidence of the role of financial development on financial constraints.

Research Article
Copyright © School of Business Administration, University of Washington 2006

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