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Financial constraints, working capital and the dynamic behavior of the firm

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  • Chan, Rosanna

Abstract

Financial constraints are widespread in developing countries, where even short term credit is limited. Finance held by firms as working capital is a substantial proportion of sales revenue, yet the role of working capital is largely neglected by existing models of financial constraints. I present a dynamic model of the firm that incorporates working capital by introducing a delay between factor payments and the receipt of revenue. In contrast with previous models, the working capital model predicts that firms under binding constraints will substitute between labor and capital in response to demand shocks, causing investment to be countercyclical. For firms near the margin of being constrained, constraints bind when positive production opportunities arise. Output growth is therefore constrained in response to positive shocks but not to negative shocks. Simulations suggest that models without working capital may understate the predicted effects of financial constraints on production efficiency, firm profit and growth over time. I test the predictions using the recently completed Bangladesh Panel Survey for manufacturing firms. Consistent with the theory, I find evidence that constraints bind when output price increases, that investment by constrained firms is countercyclical, and that output response to positive shocks is dampened for firms that are sometimes constrained. The results also are important for policy. In order to maximize growth, efforts to relieve credit constraints should be focused on periods when demand shocks are high.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 27153.

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Date of creation: Nov 2008
Date of revision: Aug 2010
Handle: RePEc:pra:mprapa:27153

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Keywords: credit constraints; working capital; firm behavior; Bangladesh; firm theory; empirics; firm level data;

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References

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  1. repec:bla:restud:v:74:y:2007:i:2:p:391-415 is not listed on IDEAS
  2. Pablo Andres Neumeyer & Fabrizio Perri, 1999. "Business Cycles in Emerging Economies: the role of interest rates," Department of Economics Working Papers 014, Universidad Torcuato Di Tella.
  3. Steven M. Fazzari & R. Glenn Hubbard & BRUCE C. PETERSEN, 1988. "Financing Constraints and Corporate Investment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 19(1), pages 141-206.
  4. Lorenzoni, Guido & Walentin, Karl, 2007. "Financial Frictions, Investment and Tobin’s q," Working Paper Series 208, Sveriges Riksbank (Central Bank of Sweden).
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  8. Ben Bernanke & Mark Gertler & Simon Gilchrist, 1994. "The Financial Accelerator and the Flight to Quality," NBER Working Papers 4789, National Bureau of Economic Research, Inc.
  9. Bigsten Arne & Collier Paul & Dercon Stefan & Fafchamps Marcel & Gauthier Bernard & Gunning Jan Willem & Oostendorp Remco & Pattillo Catherine & Söderbom Måns & Teal Francis, 2005. "Adjustment Costs and Irreversibility as Determinants of Investment: Evidence from African Manufacturing," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 4(1), pages 1-29, October.
  10. Stephen Bond & Julie Ann Elston & Jacques Mairesse & Beno�t Mulkay, 2003. "Financial Factors and Investment in Belgium, France, Germany, and the United Kingdom: A Comparison Using Company Panel Data," The Review of Economics and Statistics, MIT Press, vol. 85(1), pages 153-165, February.
  11. Robert E. Carpenter & Bruce C. Petersen, 2002. "Is The Growth Of Small Firms Constrained By Internal Finance?," The Review of Economics and Statistics, MIT Press, vol. 84(2), pages 298-309, May.
  12. Steven M. Fazzari & R. Glenn Hubbard & Bruce C. Petersen, 2000. "Investment-Cash Flow Sensitivities Are Useful: A Comment On Kaplan And Zingales," The Quarterly Journal of Economics, MIT Press, vol. 115(2), pages 695-705, May.
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Cited by:
  1. Chan, Rosanna, 2009. "Why liquidity matters to the export decision of the firm," MPRA Paper 27154, University Library of Munich, Germany, revised Aug 2010.

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