Impact of financial distress on investment-cash flow sensitivity: evidence from emerging economy

Abstract

PurposeThe purpose of this study is to examine the impact of financial distress (FD) on investment-cash flow sensitivity (ICFS) of Indian firms.Design/methodology/approachThe study uses the system generalized method of moments (GMM) technique to investigate the effect of FD on ICFS of Indian firms during the period from 2001 to 2019.FindingsUsing FD measures like Ohlson's bankruptcy method, Altman's Z-score model and financial-distress ratio, the researchers find that FD increases ICFS and negatively affects corporate investment. The researchers’ findings explain that FD increases restrictions on external financing, which makes cash flow more important for corporate investment. Additionally, the researchers find that the effects of FD on ICFS are weak (strong) for bigger and group affiliated (smaller and standalone) firms. The study’s findings are robust to several measures of FD, group affiliation and firm size.Practical implicationsFirst, the researchers find that FD affects the ICFS, therefore, financially distressed firms should have sufficient internal funds or external funds for investment. Second, lending agencies should also consider the firms' FD condition before providing funds to secure their money. Third, investors should be very careful while investing in a financially distressed firm as we find that financially distressed firms face a decline in their investment which might reduce firm profitability.Originality/valueThis study contributes to the existing literature by providing empirical evidence by analyzing the impact of FD on ICFS in the context of India. As per the authors’ knowledge, this is the first-ever attempt to examine the effect of FD on ICFS.