Financial Factors, Firm size and Firm Potential

Using a unique dataset covering the universe of Portuguese firms and their credit situation we show that financially constrained firms are found across the entire firm size distribution, account for a larger total asset share compared to standard heterogeneous firms models, and exhibit a higher cyclical sensitivity, conditional on size. In light of these findings we reassess the importance of the firm distribution in shaping aggregate outcomes in the canonical model of heterogeneous firms with financial frictions. We augment the productivity process with ex-ante heterogeneity of firms, allowing us to match the distribution of constrained firms conditional on size. This, together with the fact that constrained firms have a higher capital elasticity, leads to up to four times larger aggregate fluctuations and capital misallocation.