The nonmonotonicity of cash-cash flow relationship: the role of uncertainty and financing constraints

Relying on panel firm-level data from an emerging economy, the paper postulates and empirically verifies the pattern of a U-shaped relationship between cash flows and cash holdings. The positive cash-cash flow sensitivity is postulated to be driven by precautionary motive, which is engendered by excessive volatility of cash flows. Therefore, cash accumulation appears to serve the primary purpose of mitigating the problem of unpredictability of cash flows. While revealing no significant cash-cash flow relationship for the majority of firms, the analysis of firm-level cash-cash flow sensitivity coefficients shows that the companies with the lowest and the highest cash flows maintain disproportionately higher cash reserves than their counterparts with intermediate cash flows. The firms exhibiting negative cash-cash flow relationship are found to be of younger age, smaller size, lower liquidity, and asset tangibility than the remainder of the research sample. These firms are evidenced to accumulate cash reserves from equity issuances, while their overall capacity to procure external financing remains impaired. Their financing patterns are reminiscent of the agency problem of ‘gambling for resurrection’. In turn, the firms exhibiting positive cash-cash flow sensitivity are documented to maintain cash reserves in order to be able to alleviate cash flow volatility.