The Cash Flow Sensitivity of Cash

Almeida, Heitor, Murillo Campello, and Michael S. Weisbach, 2004, “The Cash Flow Sensitivity of Cash,” The Journal of Finance 59 (4), 1777-1804.

Purpose:  This paper develops a model of a firm’s demand for liquidity, and uses the model to obtain a new measurement of how important financial constraints are in affecting corporate policy.

Theory:  For financially constrained firms, or for firms that expect financial constraints in the future, higher cash flows should lead to more cash on the balance sheet.  For unconstrained firms that do not expect future constraints, the level of cash flows and the amount of cash on the balance sheet should be unrelated.  If this “cash flow sensitivity of cash” can be shown to be correlated with proxies for financial constraint, it will be a useful indicator of the influence of such constraints on firm behavior.

Motivation:  The effects of financial constraints on firm behavior and firms’ financial management are two topics usually studied separately, though they are closely linked.  Most previous literature regarding this link discusses the connection between financial constraints and firm investment demand.  There is a robust debate around this, with no clear consensus on what the empirical evidence means.  One complication with the literature is that current investment demand is correlated with future investment demand (since current investments impact cash flow).  Cash balances are not inherently linked to cash flows, and so are unrelated to future investment demand.  Therefore, the link between cash balances and financial constraints is less problematic to measure.

Empirical Evidence:  Using a large sample of manufacturing firms from 1971-2000, divide firms into subgroups on proxies for financial constraint.  Measure the cash flow sensitivity of cash for each group.


  • Firms exhibiting proxies for financial constraint hold 15% of assets as cash, compared to only 8-9% for firms that are not under [proxied] financial constraint
  • For 4 of the 5 financial constraint proxies, the firms expected to be constrained have the higher cash sensitivity to cash flows
  • Cash flow sensitivity of cash is a useful method for identifying financially constrained firms