Retail Inventories, Internal Finance, and Aggregate Fluctuations: Evidence From Firm-Level Panel Data

This paper investigates the cross-sectional and time-series implications of capital imperfections for inventory investment in retail trade. In particular, it focuses on the relevance of firms� balance sheet positions in obtaining access to external sources of finance. The paper utilizes an entirely new source of firm-level data at a quarterly frequency; the micro data underlying the published Quarterly Financial Reports (QFR). Under the maintained hypothesis, firms with �weak� balance sheet positions face a higher-and quite possibly prohibitive-premium on external finance than do firms with �strong� balance sheet positions. Consequently, inventory investment decisions of firms with �weak� balance sheet positions are in large part determined by the availability of internally generated funds-that is, profits or cash flow. A panel data modification of an error-correction model that incorporates internal finance variables and forward-looking expectations of the stochastic process of sales is not rejected by the data. Both the cross-sectional and time-series results are consistent with the existence of capital market imperfections; namely, (1) internal finance is a highly significant-statistically and economically-predictor of inventory investment of firms with �weak� balance sheet positions; and (2) the predictive power of internal finance for inventory investment of firms with �weak� balance sheet positions is highly asymmetric over the course of a business cycle, increasing considerably in recession relative to expansionary times. The quantitative significance of financial factors suggest that a large portion of the observed volatility aggregate retail inventory investment over a business cycle is potentially due to fluctuations in internal finance.