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Financial conditions, financial Financial

conditions,
constraints and investment-cash constraints,
cash flow
flow sensitivity: evidence from
Saudi Arabia
Moncef Guizani and Ahdi Noomen Ajmi Received 16 December 2019
Revised 20 April 2020
Department of Business Administration, 8 July 2020
College of Science and Humanity Studies in Sulayel, Accepted 2 August 2020
Prince Sattam Bin Abdulaziz University, Al Kharj, Saudi Arabia

Abstract
Purpose – The purpose of this paper is to examine whether the sensitivity of investment to cash flow varies
with exogenous financial conditions.
Design/methodology/approach – A dynamic model of investment based on the Euler equation approach is
employed to investigate the impact of macro-financial factors on the sensitivity of investment to cash flow. The
sample comprises data from 84 non-financial firms listed on Saudi stock market over the period 2007–2018.
Findings – The results show that the sensitivity of investment to cash flow is positive, implying the presence
of financing constraints for Saudi firms. Evidence also reveals that better financial conditions relax firms’
financing constraints. However, contractionary monetary policy, poor financial development and liquidity
crisis strengthen the dependence of firms on internally generated funds when undertaking new investment
projects.
Practical implications – The empirical results have useful policy implications. First, policymakers should
pay attention to the importance of policymaking based on the monetary demand of microeconomic entities. In
monetary contraction periods, firms face greater challenges in accessing external finance. These firms are
likely to experience under-investment which at a macro level would translate into lower investments and
economic growth for the country. Second, policymakers are encouraged to implement complementary
measures that, coupled with existing financial reforms, may promote efficiency, competitiveness and
transparency in firms’ operations. Finally, managers and investors should consider financial structure and
condition as important factors in their investment decision.
Originality/value – This study extends previous research by investigating whether the widely reported
positive investment and cash flow relationship can be observed using data from an emerging market,
specifically Saudi Arabia. It also sheds light on the investment-cash flow debate under a macroeconomic
perspective and provides further evidence on the impact of financial crisis on the investment-cash flow (ICF)
sensitivity.
Keywords Investment-cash flow sensitivity, Financial constraints, Monetary policy, Financial development,
Financial reform, Financial crisis
Paper type Research paper

1. Introduction
The debate about the effects of financing constraints on the corporate investment is
increasing, especially following the pioneering study of Fazzari et al. (1988). Under imperfect
market conditions, external financing is more costly than internal funds because of frictions
arising from asymmetric information, agency problems and transaction costs. As a result,
corporate investment is constrained by the availability of funds with high cost of finance.
Under such conditions, Fazzari et al. (1988) document that financially constrained firms are
more reliant on their internally generated funds while making investment decisions. Journal of Economic and
Administrative Sciences
Several subsequent studies support the finding of Fazzari et al. (1988) and state that © Emerald Publishing Limited
1026-4116
changes in the cost of external finance are the driving force behind the sensitivity of DOI 10.1108/JEAS-12-2019-0132
JEAS investment to internal generated funds (e.g. Laeven, 2003; Mulier et al., 2016; Rashid and
Jabeen, 2018).
In an important contribution to this strand of literature, some authors provided evidence
that financing constraints are driven by macroeconomic factors. Levy (2007) argues that
macroeconomic conditions are an important component of the debt-equity choice. Poor
macroeconomic conditions may crucially alter firms’ balance sheets leading to limiting their
access to financial markets. Economic downturns reduce the availability of capital, especially
for financially weak firms. Love (2003) argues that financial development is considered to
promote capital market efficiency and therefore alleviates firms’ financing constraints.
According to Masuda (2015), the liquidity constraints of firms increase as the monetary policy
becomes tight. Gul and Tastan (2018) suggest that macro-financial conditions matter in terms
of firms’ financing constraints. Gupta and Mahakud (2019) argue that movements in financial
variables, such as interest rates, exchange rates, asset prices, credit demand and development
of financial institutions may indirectly affect firms’ investment via their impacts on financing
constraints, that is, the sensitivity of investment to internal funds.
Accordingly, as stated by Bond et al. (2003), once we move away from a model of perfect
capital markets, we raise the possibility that macroeconomic factors may have different
effects on the cash flow-investment relationship.
The vast majority of the financial literature focuses on micro-determinants of the
investment and internal fund relationship. Scarce effort has been devoted to the study of the
relationship between macroeconomic factors and the sensitivity of investment to internal
funds. Rather, most of previous studies on the link between corporate investment and cash
flow have explored the issue for developed countries with little attention to the emerging
markets. As stated by Rashid and Jabeen (2018), in developing countries, firms probably face
higher financial constrains, as financial markets in these countries are more likely to
experience the financial frictions. To address this gap in the literature, this study examines
whether financial conditions in KSA affect firms’ investment in terms of their influence on
financing constraints. In particular, we pose the following two questions. Do better financial
conditions relax the financing constraints of firms? What type of firms is most likely to
benefit from financial conditions? According to Hatzius et al. (2010), financial conditions mean
the current state of financial variables that influence economic behavior. They include
anything that characterizes the supply or demand of financial instruments relevant for
economic activity. Tran and Le (2017) suggest that financial conditions capture short-term
macroeconomic fluctuations or financial shocks that could disturb firms’ investment
decisions.
This study focuses on Saudi economy to examine the effect of financial conditions on
ICF sensitivity. Many factors motivated the choice of KSA as the research location for this
study. First, Saudi Arabia maintains a policy of open capital accounts in that the Saudi
Arabian Monetary Agency (SAMA) maintains a fixed exchange rate system. The riyal
interest rates closely track dollar rates, often with a small premium, since the mid-1980s
(Dibooglu and Aleisa, 2004). Second, Bank financing and lines of credit dominates financing
channels for corporate in KSA. Bank credit continues to be the most popular financing
channel, catering to more than 80% of the total funding needed (Aljazira Capital, 2010).
Third, in the mid-2015, KSA implemented a capital market reform aimed at increasing
foreign investor access, streamlining processes and enhancing transparency. Fourth, Saudi
Arabia has the second most valuable natural resources in the world. They are the largest
exporter of petroleum in the world and have the fifth largest proven natural gas reserves.
That means, investment opportunities or financing opportunities, and capital market and
monetary growth of this economy are largely depending on the petroleum price. Finally,
most businesses in the KSA have few controlling shareholders, and family ownership is
predominant. Further, business group affiliation is a very important issue in the context of
Saudi corporate sector (Eulaiwi et al., 2016). Therefore, such market conditions are expected Financial
to have a significant impact on the relationship between corporate investment and internal conditions,
financing.
There are several important areas where this study makes an original contribution to the
constraints,
related literature. First, it sheds light on the sensitivity of investment to cash flow debate cash flow
under a macroeconomic perspective. While prior works (e.g. Hovakimian, 2009; Mulier et al.,
2016; Bhabra et al., 2018) use firm-specific variables, this study focuses on macro variables
like monetary policy, financial development, and financial reforms as potential determinants
of ICF sensitivity. In particular, this study explores the macro determinants of firms’
investment-cash flow relationship through a financing constraints approach. Second, this
study focuses on an emerging Saudi economy where the regulatory and institutional
constraints are different from other developed and emerging economies. In fact, several
factors combine to create a distinctive environment for financial research to examine the
effect of financial conditions on ICF sensitivity. To the best of our knowledge, this study is the
first to focus on KSA context. Third, the present paper provides further evidence on
the impact of financial crisis on the ICF sensitivity of KSA firms. The last financial crisis has
been developed into a full-blown liquidity shortage with potentially severe consequences for
KSA economy. Stock market experienced a significant decline with a dramatically market
capitalization drop between September 2008 and end-2008 (Kahle and Stulz, 2013; Drobetz
et al., 2017). Finally, this study examines whether family control and group affiliation have an
effect on the ICF sensitivity.
The remainder of this paper is organized as follows. Section 2 reviews theoretical and
empirical literature and develops the hypotheses. The sample and the methodology are
discussed in Section 3. Section 4 analyses the empirical results. Section 5 concludes.

2. Literature review and hypothesis development

2.1 Cash flow sensitivity of investment
Theoretical and empirical research shows that market frictions make external financing more
costly than internal financing. Accordingly, when firms face difficulty to access to external
funds to attain further growth, their future development will be limited to internally
generated funds. Despite the largely observed positive relationship, the controversy has been
on what explains the relationship between investment and cash flow. The related literature
highlights two alternative explanations for a positive relationship between cash flow and
investment spending. The asymmetric information explanation and the agency cost
explanation. Asymmetric information between the firm insiders and external capital
providers may lead to under-investment problems because external financing may be
deemed overly expensive by the management (Myers and Majluf, 1984). Agency costs are
incurred when he interests of the principal and agent are not aligned. Managers’ corporate
objective may be growth rather than value. Possible deceitful actions are the diversion of
funds away from the productive project resulting in overinvestment (Jensen, 1986).
Extant literature has investigated and reported the responsiveness of corporate
investment spending to internal funds. In their seminal work, Fazzari et al. (1988) report
that the sensitivity of investment to cash flow is stronger for firms that have higher financial
constraints. They classify firms according to whether they were likely to be financially
constrained on the basis of dividend payouts. They find significantly higher sensitivity of
investment to internally generated funds in low-payout compared to high-payout firms.
Many further studies have showed their strong support towards the findings of Fazzari et al.
(1988). For instance, Pawlina and Renneboog (2005) investigate the ICF sensitivity of a large
sample of the UK listed firms and confirm that investment is strongly cash flow sensitive.
They also find that the sensitivity of investment to internal funds results mainly from the
JEAS agency costs of free cash flow. Using a sample of unquoted European small and medium sized
firms, Mulier et al. (2016) find that constrained firms display the highest ICF sensitivity. El
Gaied (2018) finds a positive relationship between investment and internal financing for a
sample of 150 US firms. The author concludes that ICF sensitivity seems to be explained
mainly by the hypothesis of managerial discretion.
However, other researchers have challenged the results of Fazzari et al. (1988). Kaplan and
Zingales (1997), Cleary (1999) and Bhabra et al. (2018) demonstrate that ICF sensitivities of
financially unconstrained firms are in fact higher relative to those of constrained firms. The authors
point out that the classification adopted by Fazzari et al. (1988) tends to assign firms incorrectly.
Building on financial constraints from the Fazzari et al. (1988) methodology, we test the
following hypotheses:
H1a. We expect a positive relationship between cash flow and investment.
H1b. More financially constrained firms exhibit higher investment-cash flow sensitivity
than less financially constrained firms.

2.2 Investment-cash flow sensitivity and financial conditions

According to Hatzius et al. (2010), financial conditions reflect the actual state of supply or
demand of financial instruments relevant for economic activity. Macroeconomic
fluctuations caused by such financial conditions may indirectly affect firm investment
via their impacts on financing constraints, that is, the sensitivity of investment to internal
funds. Monetary policy stance is one of the most significant macro-financial conditions in
the market economy. A related stand of literature considers the monetary policy to be an
important factor in explaining the investment-cash flow relationship. Several papers
including Bernanke and Gertler (1989) and Bernanke et al. (1999) develop theoretical models
to capture the effect of the monetary policy on firms’ financial decisions based on the
financial accelerator theory. All these models appear to suggest that adverse shocks to the
economy may be amplified by worsening credit-market conditions, which in turn influence
financial decision-making and the investment behavior of firms. Tran and Le (2017) provide
support to the financial accelerator theory argument. They identify two channels by which
monetary policy impacts output: the neo-classical cost of capital channel and the credit
channel. Monetary policy shocks affect firms’ external financing constraints, and thereby
their investment behavior.
During the last decade, a number of empirical studies have investigated the relationship of
monetary policy to firms’ financial decisions. Huang et al. (2012) examine the influence of
monetary policy changes on Chinese firms’ investment. The authors stress that monetary policy
changes influence firms’ financial behavior. A tight monetary policy raises the external financial
risk premium, which will affect financial decision-making and the investment behavior of firms.
Their empirical results reveal a significant positive relationship between money supply and a
firm’s investment. This implies that expansionary (tight) quantity based monetary policy will
drive the firm to increase (decrease) its investment. Yang et al. (2017) study whether cash holding
mitigates the effect of tight monetary policy on corporate investment. They find that the higher
liquidity level firms enjoy, the more insulated are the firms from monetary policy shocks.
Particularly, the cash mitigating role is more prominent for financially constrained firms and
those located in less developed markets. Using a sample of Turkish firms, Gul and Tastan (2018)
provide evidence that the monetary policy stance significantly affects firms’ financing
constraints. In particular, ICF sensitivity declines during expansionary monetary policy
periods. Accordingly, from the above discussion, the second hypothesis would stand as:
H2. Contractionary (expansionary) monetary policy increases (decreases) the sensitivity
of corporate investment to cash flow.
Many studies argue that financial market development relaxes the connection between Financial
internal resources and firm investment. In particular, financial development plays an conditions,
important role in alleviating informational asymmetries in financial markets. Bond et al.
(2003) highlight the benefits of well-developed financial systems in minimizing transaction
constraints,
costs and overcoming informational asymmetries. Under these circumstances, firms are cash flow
encouraged to use external funding sources to fund investment. The empirical findings show
that the effect of financial constraints on firm investment become weaker when there is
financial development. Similar results are reported by Becker and Sivadasan (2010), who
conclude that financial development can mitigate financial constraints faced by the firm. The
results from Lerskullawat (2018) agree with the findings of prior studies in terms of the
relationship between financial development and financial constraints. Using data from non-
financial companies in Thailand, the author finds evidence that financial development
weakens the effect of financial constraints on corporate investment. In particular, more
constrained firms benefit more from financial development than less constrained ones. In a
more recent paper, Gupta and Mahakud (2019) report that financial development reduces the
ICF sensitivity and the effect of financial development is considerably higher in small size and
standalone firms. This discussion leads to the following hypothesis:
H3. Financial development reduces the sensitivity of corporate investment to cash flow.
Most developing countries have initiated financial liberalization process in the past decades.
Financial reforms are considered to promote capital market efficiency and therefore alleviate
firms’ financing constraints. According to Laeven (2003) financial liberalization is thought to
reduce the imperfections of financial markets, resulting in a reduction in the cost of capital
and an increase in the level of investment. In line with this argument, Guermazi (2014)
suggests that various liberalization policies play the role of reducing asymmetric information
problems in financial markets. Developments in financial market result in a reduction of the
cost of external financing. Consequently, financial liberalization reduces the wedge between
the costs of external and internal funds and thereby decreases the cash-flow effect on
investment of financially constrained firms.
Empirical literature produces mixed results of the effect of financial liberalization on
financial constraints. In one stream of empirical research, the findings indicate no effect
of financial reforms on firms’ financial constraints. Jaramillo et al. (1996) investigate whether
financial reforms introduced in the 1980s were successful at reducing financial constraints for
Ecuadorian firms. They find that small and young firms were subjected to financing
constraints while large and old firms were not; and there is no evidence to suggest that
financial reforms helped reduce the constraints for small firms. Similarly, Hermes and
Lensink (1998) do not find evidence supporting the hypothesis that financial reforms in Chile
in 1980s contributed to reducing market imperfections for small firms.
However, a second stream of research finds that financial liberalization plays the role of
relaxing financial constraints on firms and thereby reduces the sensitivity of investments to
cash flow. Using panel data set on Korean firms, Koo and Maeng (2005) find that previously
constrained firms, such as small, independent, and old firms have benefited more from
financial liberalization. These firms get better access to outside financing after liberalization.
Bhaduri (2005) examines whether financial reforms have reduced financing constraints of
publicly-listed Indian firms. The empirical findings reveal evidence in favor of the hypothesis
that the liberalization effort has succeeded in relaxing financial constraints faced by the
Indian firms. In a recent study, Gopalan and Sasidharan (2020) indicate that several emerging
market and developing economies embracing financial liberalization enjoy a growing
presence of foreign banks tending to ease firms’ credit constraints.
In the Saudi context, the CMA formally released the “Rules for Qualified Foreign Financial
Institutions Investment in Listed Shares” on 04/05/2015. The Rules became effective from
JEAS 01/06/2015 and mark a significant move towards the long-awaited opening of the KSA capital
markets to foreign investment. The rationale behind opening up the stock exchange for direct
foreign investment is particularly the improvement in market stability and a reduction in
pricing volatility as well as the increase in local expertise of financial markets.
The above discussion leads to the following hypothesis:
H4. Financial reform reduces the sensitivity of corporate investment to cash flow.
Moreover, based on the results of the recent global financial crisis, some research papers have
discussed the external financing constraints faced by firms. The regional bank failures that
result from the last crisis have led to a shock to the supply of credit. As argued by Almeida
et al. (2011) and Kahle and Stulz (2013), banks faced severe liquidity constraints during the
last financial crisis, which resulted in more reluctance to lend. Consequently, companies were
affected by a severe credit-supply shock, which changed firms’ investment decisions.
The literature generally provides studies that focus on the effects of financial crisis on the
aggregate investment levels of economies. Little is known about the firm-level investment.
Campello et al. (2010) survey 1,050 Chief Financial Officers in the US, Europe, and Asia to
directly assess credit constraints faced by firms during the last financial crisis. Their result
indicates that constrained firms planned deeper cuts in tech spending, employment, and
capital spending. They also show that the inability to access external financing caused many
firms to bypass attractive investment opportunities. La Rocca et al. (2016) find a stronger link
between investment and cash flow during the recent global financial crisis for a sample of
Italian manufacturing firms. They also find that financially constrained firms exhibit a
higher ICF sensitivity because of more stringent conditions for accessing external financing
sources. Similar results are reported by Drobetz et al. (2017), who find that the recent financial
crisis was especially severe for financially weak firms and curtailed both their investment
and financing decisions. The results of Gul and Tastan (2018) align with the literature’s
argument that the global financial crisis has led banks and other financial institutions to more
reluctance to lend which limits firms’ access to external finance. This results in greater
sensitivity of corporate investment to internal funds during this crisis. Considering these
arguments, we pose the following hypothesis:
H5. Financial crisis increases the sensitivity of corporate investment to cash flow.

3. Data description and methodology

3.1 Data sources and sample
The sample used in the research consists of all Saudi non-financial firms listed on the Saudi
stock exchange. The study requires two types of information to estimate the proposed
models: micro and macro information. At a micro level, the data used in this study is hand-
collected from the company financial reports published annually by the “argaam” website
(https://www.argaam.com) that contains the balance sheets, income statements and
information on several characteristics of Saudi listed firms. The macroeconomic variables
are collected from the annual statistics 2018 available in the SAMA website http://www.sama.
gov.sa.
We have constructed a data panel of non-financial quoted Saudi companies for the period
ranging from 2007 to 2018. The original sample frame includes 178 listed firms categorized
into ten sectors according to the Saudi stock exchange official classification.
To be included in the sample, firms have to be listed on a Saudi stock exchange. First, we
focus exclusively on non-financial firms and exclude banks and insurance companies
because of their specific rules and regulations. Second, we limit our sample to the period for
which macroeconomic variables were available. Finally, our methodology imposes an
additional restriction to account for the unobservable heterogeneity and endogeneity Financial
problems. Therefore, we need at least four consecutive years of information per company to conditions,
test for the absence of second-order serial correlation because our estimation method, the
GMM, is based on this assumption (Pindado et al., 2011). As a result, the final sample is an
constraints,
unbalanced panel comprised of 116 firms with a total of 1,262 firm-year observations. cash flow
Panel A of Table 1 displays the sample selection procedure over the period 2007–2018. Our
initial sample comprises 178 KSA listed firms. We exclude 48 bank and insurance companies,
14 firms with missing four consecutive financial reports, giving us a final sample of 116 firms
with a total of 1,262 firm-year observations. Panel B of Table 1 shows that 30.35% of our
sample is derived from the Material sector, followed by firms belonging to the Consumer
Goods (21.55%), Consumer Services (16.48%), Capital Goods (9.35%) and Real Estate
Development (8.24%).

3.2 Model design and definition of key concepts

3.2.1 The Euler investment equation model. The present study adopts a standard investment
model based on the Euler-equation approach used by Gupta and Mahakud (2019), Gul and
Tastan (2018), Tran and Le (2017), and Laeven (2003). As discussed by the authors, the Euler
approach presents three important advantages. First, it avoids the use of share price data.
Second, it can relax the assumption of linear homogeneity of the net revenue function. Third,

No. of companies Percentage of sample

Panel A: Industrial composition of firms listed on the “Tadawul” available to be sampled as of December 31, 2018
Materials 42 23.59
Energy 4 2.25
Consumer service 22 12.36
Consumer goods 28 15.73
Capital goods 12 6.74
Real estate development 11 6.18
Telecommunication 4 2.25
Financial 48 26.97
Transportation 5 2.81
Utilities 2 1.12
Total firms available to be sampled 178 100
Less: financial companies 48
Firms with missing four consecutive reports 14
Total excluded firms 62 34.83
Final selected sample 116 65.17
Panel B: Industrial composition of the sample
Materials 383 30.35
Energy 48 3.80
Consumer service 208 16.48
Consumer goods 272 21.55
Capital goods 118 9.35
Real estate development 104 8.24
Telecommunication 48 3.80
Transportation 57 4.52
Utilities 24 1.90 Table 1.
Final selected sample 1,262 100 Summary of the
Note(s): Panel A contains the yearly final sampled corporation with full data. Panel B displays firm sample selection
classification by business sector based on the classification adopted by Saudi stock market procedure
JEAS it avoids the need to parameterize the expectations-formations process as in the case of the
q-model of investment.
The Euler equation in the linear form is specified as:





I=K ¼ β0 þ β1 I=K þ β2 S=K þ β3 CF=K þ ϑi þ λt þ μit (1)
it it−1 it it

where, I represents net investment, K is capital stock at the beginning of the period, S is net
sales. ϑi is the firm specific effects, λt is the time specific effect, μit is white noise. The
subscripts i, and t, represent the firms and time respectively.
As previously discussed, we include in the right-hand side of our empirical specifications
the lag of the dependent variable (I/K)it1 to account for the dynamics of the investment
policy and to capture the accelerator effect of this corporate decision (Pindado et al., 2011). The
investment-cash flow hypothesis is then considered supported if the coefficient β3 is
significantly positive and higher in financially constrained subsample (e.g. Fazzari et al., 1988;
Pawlina and Renneboog, 2005; Gul and Tastan, 2018). Sales to capital ratio (S/K) is expected
to affect firm investment as proxy variable for growth opportunities (e.g. Tran and Le, 2017;
Gupta and Mahakud, 2019). Firms with high growth opportunities will be in greater need of
financing, making liquidity constraints more binding.
This study examines the role of financial conditions on corporate investment in terms of their
influence on financing constraints. Considering the effect of financial conditions on ICF sensitivity and
the direct effect of financial conditions on corporate investment, the model is specified as follows:






I=K ¼ β0 þ β1 =K I þ β2 =K þ β3
S CF =K þ β4 CF =K 3 FICt þ β5 FICt
it it−1 it it it
þ ϑi þ λt þ μit
(2)

where FIC is a dummy variable that refers to financial conditions defined in Table 2.
The interaction term in Eqn (2) captures the effect of financial conditions on the sensitivity
of investment to internal funds. The magnitude of this effect is captured by (β3 þ β4 3 FIC).
The KSA business environment is considered to be family-dominated, and family
controlled firms are represented by a small number of family investors (Eulawi et al., 2016).
Some of the specificities inherent to the family shareholders, such as high risk aversion and

Abbreviation Description

Kt Capital at the end of period t (5 tangible fixed assets at the end of the period t)
It Investment expenditure during the period t (Ktþ1 þ Depreciationst  Kt)
CFt Cash flow during the period t (5 net profit after tax þ Depreciation during period t)
St Sales during the period t
FICt Financial condition during the period t decomposed as
MPt The monetary policy during the period t: it is contractionary (takes the value 1) when the
central bank raises the rates, otherwise it is expansionary (takes the value 0)
FINt The financial market development measured by market capitalization plus private credit,
normalized by GDP. FIN Equals 1 when there is a rise and 0 when there is a decline
REFt Financial market reform. Equals 1 after the 2015 reform and 0 before 2015 reform
CRISISt Equals 1 in the crisis period (2007, 2008 and 2009) and 0 otherwise
FAM Equals to 1 if the firm has an owner at the 20% threshold that is a family or an individual and
Table 2. zero otherwise
Variables definitions GROUP Equals 1 for group affiliated firms and zero otherwise
reluctance to share firm control, may exacerbate investment-cash flow sensitivity in family Financial
firms. Therefore, we estimate another equation to investigate whether family control affects conditions,
the sensitivity of investment to cash flow.





 constraints,
I=K ¼ β0 þ β1 I=K þ β2 S=K þ β3 CF=K þ β4 CF=K 3 FAMit cash flow
it it−1 it it it (3)
þ β5 FAMit þ ϑi þ λt þ μit

where FAM is a dummy variable that equals 1 if the firm has an owner at the 20% threshold
that is a family or an individual, and zero otherwise (La Porta et al., 1999).
Next, as business group affiliation is a very important issue in the context of Saudi
corporate sector, we try to test whether the affiliation to a business group affects the
sensitivity of investment to cash flow.






I=K ¼ β0 þ β1 I=K þ β2 S=K þ β3 CF=K þ β4 CF=K 3 GROUPi
it it−1 it it it (4)
þ β5 GROUPi þ ϑi þ λt þ μit

where GROUP is a dummy whose value is 1 for group affiliated firms and zero otherwise.
3.2.2 Estimation method. We estimate the above equation using first-difference GMM
(Arellano and Bond, 1991). To ensure that the Arellano-Bond estimator is appropriate for this
investment model, we use the Sargan-test of over identifying restrictions as a joint test of
model specification and instrument selection. An insignificant Sargan-test statistic indicates
that orthogonality of the instruments and the error terms cannot be rejected, which implies
that the choice of instruments is appropriate. To perform tests of serial correlation in the error
terms, we employ Arellano-Bond AR(1) and AR(2) tests. The AR(1) tests the null hypothesis
of absence of first order autocorrelation against the alternative hypothesis of existence of first
order autocorrelation. The AR(2) tests the null hypothesis of absence of second order
autocorrelation against the alternative hypothesis of existence of second order autocorrelation.
To ensure that all the lags of the dependent variable and other instrumental variables are
strictly exogenous, the residual terms of the first difference equation must be correlated in the
first-order test but not in the second-order test.

4. Regression results
4.1 Descriptive analysis
Panel A of Table 3 provides the main summary statistics for the variables used in the empirical
analyses. For the full sample, net investment over capital stock ratio (I/K) has a mean and
median of 0.126 and 0.131, respectively. The average cash flow to capital stock ratio a firm holds
is 13.8% and the median value is 10.6%. The mean and median values are, respectively 65.4 and
58.8% for sales ratio (S/K). As for macro-financial variables, the average interest rate in KSA
during the study period is 2.84% and has a median of 2.25%. The mean value of financial
market development, measured by market capitalization plus private credit normalized by
GDP, is 1.171 with a standard deviation and median value of 0.349 and 1.205, respectively.
Panel B of Table 3 provides descriptive statistics (mean and standard deviation) for firm
specific variables used in the multivariate analyses by splitting the sample into several
groups. It is noticeable that the behavior of the variable ratios suggests traits of more
constrained firms (low dividend paying) that differ from their less constrained peers (high
dividend paying). First, more constrained firms generate less internal funds relative to those
with less financial constraints. This exacerbates financial problems for constrained firms by
increasing the needs for external financing. Second, financially constrained firms have lower
 JEAS

analysis
Table 3.

and descriptive
Summary statistics
Panel A: summary statistics for the full sample
Variable Mean SD p25 Median p75

I/K 0.126 0.204 0.062 0.131 0.108

CF/K 0.138 0.178 0.042 0.106 0.171
S/K 0.654 0.443 0.246 0.588 0.527
MP 2.840 1.235 2.000 2.250 4.000
FIN 1.171 0.349 0.942 1.205 1.251

Panel B: summary statistics by group of firms

I/K CF/K S/K
Firms Mean (std.) Mean (std.) Mean (std.)

High dividend paying firms 0.144 (0.272) 0.147 (0.114) 0.697 (0.465)
Low dividend paying firms 0.092 (0.184) 0.083 (0.113) 0.588 (0.397)
Family-controlled firms 0.116 (0.225) 0.156 (0.192) 0.622 (0.431)
Non family-controlled firms 0.143 (0.187) 0.074 (0.125) 0.698 (0.466)
Group affiliated firms 0.184 (0.321) 0.164 (0.138) 0.704 (0.482)
Standalone firms 0.107 (0.162) 0.112 (0.134) 0.614 (0.477)

Panel C: univariate tests according to financial conditions

Mon. policy Fin. dev Fin. reform Fin. crisis t-statistic t-statistic t-statistic t-statistic
1 0 1 0 1 0 1 0 (1)–(2) (3)–(4) (5)–(6) (7)–(8)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)

I/K 0.106 0.148 0.134 0.112 0.131 0.124 0.096 0.142 4.586*** 2.024** 1.486 4.887***
*** ***
CF/K 0.174 0.116 0.121 0.152 0.144 0.136 0.155 0.130 5.148 2.876 1.228 2.982***
S/K 0.623 0.684 0.672 0.634 0.662 0.650 0.608 0.688 2.482** 2.124** 0.896 3.436***
Note(s): Panel A displays summary statistics (means, standard deviations, p25, medians and p75) of the dependent and independent variables of the regression models.
Panel B presents summary statistics (means and standard deviations) of firms classified according to dividend payout, family control and group affiliation. Panel C reports
difference-in-means estimates of the dependent and independent variables according to financial conditions as defined in Table 2. The full sample consists of 1,262 firm-
years from Saudi Arabia between 2007 and 2018. ** and *** indicate significance at the 5% and 10% level, respectively
sales to capital ratio than financially unconstrained firms. This suggests that the existence of Financial
financial constraints can obviously have important effects on the firm’s ability to grow and conditions,
stay in the market. The results also indicate that family-controlled firms have higher cash
flow ratio than non-family-controlled firms. However, family-controlled firms invest less than
constraints,
their non-family-controlled counterparts. These preliminary findings suggest that family- cash flow
controlled firms heavily rely on internal funds for investment.
As shown in Panel B of Table 3, the cash flow and investment to capital ratio of group
affiliated firms are higher than those of standalone companies. This reflects a distinguishing
characteristic of group affiliated firms that rely on internal resources to fund investment projects.
To investigate the differences that exist between firms according to financial conditions,
we carry out a difference of means test for all variables used in the multivariate analyses. The
results reported in Panel C of Table 3 show that investment to capital ratio, sales to capital
ratio and cash flow to capital ratio significantly differ according to financial conditions. In
tight monetary policy periods, firms reduce their investment, but, at the same time, hold more
cash flow. A rise in interest rate exacerbates the corporate borrowing constraints, which
induce a drop in firms’ investment level. Consequently, companies become more dependent
on internal financing or reduce current investment to dynamically adjust their scale of
investment. In contrast, as highlighted in the panel, investment to capital ratio increases and
cash flow decreases with financial development. An improvement in the functioning of
financial markets reduces the financial constraints faced by the firm, thereby, declines their
dependence on internal funds for investment. With regard to financial reform, firms invest
slightly more and hold less cash flow after the financial reform but the difference is not
significant. The mean value of investment expenditures during the post-crisis period is about
48% higher than that of the crisis period. (0.142 vs. 0.096 for the post-crisis and the crisis
periods, respectively). However, the cash flow is significantly higher in crisis period
compared to post-crisis period. As supported by previous studies (Almeida et al., 2011;
Duchin et al., 2010), financial crisis induces firms to postpone capital expenditures and curtail
their ongoing investment projects.

4.2 Baseline regression

We start empirical examination of how corporate investment relates to cash flow by
estimating Eqn (1) for the full sample, as well as for more constrained and less constrained
firms separately. We categorize our sample firms as more constrained firms and less
constrained firms based on the median of dividend payout. Columns (1), (2) and (3) of Table 4
present the results for the baseline specification (Eqn (1)) examining the sensitivity of
investment to cash flow for the full sample, less constrained firms and more constrained
firms. As can be observed in Table 4, the AR(1) and AR(2) tests of Arellano and Bond (1991)
show that the residues are correlated in the first order and not in the second order. The
p values obtained by the AR(2) test and the Sargan test for the model exceed 0.10, suggesting
that the model is correctly specified. The Wald test results confirm the significance of
explanatory variables in explaining the dependent variable.
As shown in Columns (1), (2) and (3) of Table 4, the significant positive coefficient of lagged
investment implies a persistence effect in firms’ investment undertaken, that is, current
investment depends on past investment, in the sense that a higher investment in the previous
year is followed by a higher investment in the current year. These findings are consistent with
those presented by Laeven (2003), Love (2003), Tran and Le (2017) and Gupta and Mahakud
(2019) but inconsistent with the negative effect evidenced by Gochoco-Bautista et al. (2014).
As highlighted in Table 4, the cash flow has a strong explanatory power in all regressions.
The results also show that ICF sensitivity is positive for all firm classes, and is a lot larger for
more constrained firms’ group. The estimated coefficient on cash flow is positive and
JEAS Full sample (1) Healthy firms (2) Weak firms (3)

(I/K)it1 0.364 (9.12)*** 0.304 (8.15)*** 0.213 (2.44)**

(CF/K)it 0.462 (3.62)*** 0.228 (2.43)*** 0.629 (5.24)***
(S/K)it 0.195 (2.78)*** 0.234 (3.08)*** 0.116 (2.18)**
Constant 0.023 (4.44)*** 0.019 (2.32)** 0.036 (4.72)***
Sargan test 0.82 0.45 0.62
AR test
H0: AR(1) 5 0 0.00 0.00 0.04
H0: AR(2) 5 0 0.31 0.23 0.16
Wald test 162.54 76.52 104.86
N 1,262 768 494
Table 4. Note(s): This table displays results for GMM estimations of the equation in specifications (1). Columns (1), (2)
Estimation results of and (3) show coefficient estimates for the full sample, less constrained (healthy) and more constrained firms
the base (weak), respectively. The full sample consists of 1,262 firm-years from KSA between 2007 and 2018. ** and ***
investment model indicate significance at the 5% and 10% level, respectively

significant at 1%, indicating that Saudi firms are subjected to significant financing
constraints. The coefficient associated with cash flow for the overall sample is (0.462)
implying that change in cash flow from the 25th to the 75th percentile (change of 0.129) is
related to an increase in the right hand side variable by 0.0596 (0.129 3 0.462), i.e. investment
increases by 5.96% of fixed capital.
As a comparison, the magnitude of the financing constraints found here for Saudi firms,
0.462, is larger than that, 0.158, in the Euro Zone (Pindado et al., 2011), 0.109 for UK firms
(Pawlina and Renneboog, 2005) and 0.061 for US firms (Hovakimian, 2009). The difference in
these ICF sensitivities may reflect the higher market imperfections in Saudi stock market and
their consequence on the access to external funds.
Further, the higher coefficient associated with cash flow for more constrained firms
denotes limit access to external finance, thereby, a more reliance on internal resources for
investment. Thus, owing to financial frictions, it is more difficult and costly for financially
constrained firms to finance investments with external funds than with internal funds. This is
consistent with the interpretation that financially constrained firms have the incentive to
accumulate cash as a buffer against potential unavailability of affordable external financing
in the future. Under such conditions, it is mainly the supply of external finance and the
associated cost of finance that is binding for firms (Mulier et al., 2016).
Collectively, our regression results support H1a and H1b, which predict a positive
sensitivity of investment to cash flow that is more prominent for financially constrained
firms. These results are in accordance with findings reported by previous studies (e.g. Fazzari
et al., 1988; Love, 2003; Mulier et al., 2016; and Tran and Le, 2017), which find a positive and
strong relation between investment spending and cash flow. However, they are inconsistent
with those of Kaplan and Zingales (1997), Cleary (1999) and Bhabra et al. (2018), who show
that less constrained firms experience greater ICF sensitivity.
As a proxy of investment opportunities, the coefficients associated with sales are positive
and significant in all regressions. This implies that sales have a strong explanatory power for
firm investment behavior.

4.3 The effect of financial conditions on ICF sensitivity

The second set of regressions seeks to formally test whether ICF sensitivities vary with
financial conditions. Table 5 reports the results from specifications in which the cash flow
variable is interacted with financial variables (monetary policy, financial development, and
financial reform).
Dependent Monetary policy Financial development Stock market reform
variables Full sample (1) Healthy (2) Weak (3) Full sample (4) Healthy (5) Weak (6) Full sample (7) Healthy (8) Weak (9)

(I/K)it1 0.302 (8.52)*** 0.278 (7.48)*** 0.196 (2.23)** 0.338 (9.22)*** 0.246 (6.58)*** 0.184 (2.32)** 0.309 (6.26)*** 0.284 (5.42)*** 0.146 (2.66)***
(CF/K)it 0.228 (1.78)* 0.164 (2.52)** 0.443 (2.32)** 0.604 (3.03)*** 0.309 (1.90)* 0.649 (4.52)*** 0.484 (4.12)*** 0.229 (1.77)* 0.501 (3.48)***
(CF/ 0.384 (4.02)*** 0.221 (1.94)* 0.314 (2.18)**
K)it 3 MPt
(CF/ 0.247 (1.78)* 0.156 (1.74)* 0.289 (1.94)*
K)it 3 FINt
(CF/ 0.125 (1.22) 0.072 (0.68) 0.203 (1.48)
K)it 3 REFt
(S/K)it 0.224 (3.18)*** 0.308 (3.38)*** 0.202 (1.94)* 0.238 (2.84)*** 0.321 (3.77)*** 0.188 (1.78)* 0.208 (3.06)*** 0.294 (3.34)*** 0.169 (2.24)**
MPt 0.058 (2.62)*** 0.029 (1.92)* 0.042 (1.18)
FINt 0.017 (1.24) 0.014 (0.88) 0.094 (1.38)
REFt 0.018 (1.17) 0.024 (1.42) 0.042 (1.26)
Constant 0.022 (3.56)*** 0.019 (2.26)** 0.034 (3.68)*** 0.041 (3.92)*** 0.011 (1.95)* 0.028 (3.34)*** 0.016 (2.84)*** 0.011 (2.76)*** 0.009 (1.18)
Sargan test 0.62 0.41 0.74 0.53 0.28 0.62 0.21 0.43 0.18
AR test:
H0: 0.00 0.00 0.04 0.00 0.00 0.02 0.00 0.00 0.00
AR(1) 5 0
H0: 0.36 0.28 0.46 0.28 0.41 0.22 0.13 0.30 0.28
AR(2) 5 0
Wald test 173.08 79.82 134.16 112.56 96.08 106.87 102.44 101.77 74.32
N 1262 768 494 1262 768 494 1262 768 494
Note(s): This table displays results for GMM estimations of the equations in specification (2). Columns (1), (2) and (3) show coefficient estimates for the full sample, healthy
and weak firms, respectively. Columns (4), (5) and (6) report results of the effect of monetary policy on the ICF sensitivity for the full sample, healthy and weak firms,
respectively. Columns (7), (8) and (9) display results of the financial development effect on the ICF sensitivity for the full sample, healthy and weak firms, respectively.
Columns (10), (11) and (12) display results of the financial market reform effect on the ICF sensitivity for the full sample, healthy and weak firms, respectively. The full
sample consists of 1262 firm-years from KSA between 2007 and 2018. *, ** and *** indicate significance at the 1%, 5% and 10% level, respectively
constraints,
conditions,

Estimation results of
cash flow
Financial

macro-financial factors
the impact of the
Table 5.

on ICF sensitivity
JEAS 4.3.1 Monetary policy and ICF sensitivity. The first, second and third Columns of Table 5
present the results of the specifications with interaction of cash flow and monetary policy
stance. MP stands for the dummy variable representing monetary policy (contractionary 5 1,
expansionary 5 0).
Of key importance is the interaction term between monetary policy (MP) and cash flow. If
firms face higher financial constraints in contractionary monetary policy periods, then they
rely more on their internal generated cash flow to provide funding of their valuable
investments. As shown in Table 5, the interaction coefficient between monetary policy and
cash flow is positive and significant.
The sensitivity of investment to cash flow can be expressed as (0.228 þ 0.384 3 MP) based
on the results reported in Column (1) of Table 5. This indicates that the ICF sensitivity is 0.228
in expansion years lower than 0.612 in contraction years. Therefore, we conclude that
although cash flow continues to affect investment positively and significantly in contraction
years, the effect is considerably higher in comparison with expansion years. These results
support H2, which proposes that contractionary monetary policy increases the sensitivity of
corporate investment to cash flow. This finding is driven by the increased corporate
borrowing constraints that result from a rise in interest rates. As discussed by Vithessonthi
et al. (2017), changes in monetary policy affect market interest rates, i.e. the cost of funds to
firms. The higher cost of a firm’s (financial) capital (i.e. the hurdle rate) for projects is likely to
increase its dependence on internal generated funds. Our result aligns with the financial
accelerator theory that a rise in interest rates will influence firms’ debt, erodes cash flow and
reduces the value of collateral (Huang et al., 2012). As a result, firms will face an increased
external financial risk premium, which will affect their investment behavior and suppress
their demand for loans.
In contrast, expansionary monetary policy reduces a firm’s ICF sensitivity and that it
has a statistically and economically significant impact on financing constraints. When the
monetary authorities promulgate expansionary monetary policies, businesses will tend
to borrow and invest more and more. Therefore, their reliance on internal cash flow will
be reduced.
Results also show that the impact of monetary policy stance on the ICF sensitivity differs
among more constrained (weak) and less constrained (healthy) firms. The magnitude of the
monetary policy effect is especially significant for financially weak firms suggesting that
firms that suffer from financial frictions are likely to be more affected during contraction
years. The results indicate that the effect of cash flow on investment in contraction years is
0.757 ð b β2 þ bβ3 ¼ 0:443 þ 0:314 ¼ 0:757Þ for more constrained firms larger than 0.385
ðbβ2 þ b β3 ¼ 0:164 þ 0:221 ¼ 0:385Þ for less constrained firms.
Collectively, our regression results support the findings obtained by prior studies that
examine the association between monetary policy and investment policy. Abdul Karim (2010)
shows that small firms which faced financial constraint respond more to monetary tightening
as compared to the large firm (less constrained firms). Yang et al. (2017) find that tightening
monetary policy reduces corporate investment while cash holdings mitigate such adverse
effects. In particular, the cash mitigating role is more prominent for financially constrained
firms. To their part, Tran et al. (2019) find that the expansionary monetary policy not only
encourages the borrowing activities but also results in more corporate investment activities.
4.3.2 Financial development and ICF sensitivity. This study investigates the effect of
financial development on the ICF sensitivity by testing Hypothesis 3, which states that there is
a negative relationship between financial development and the sensitivity of investment to cash
flow. The fourth, fifth and sixth Columns of Table 5 present the results of the specifications with
interaction of cash flow and financial development. FIN stands for the dummy variable
representing financial development (rise 5 1, decline 5 0).
 The regression results reported in column (4) show a negative and significant coefficient Financial
associated with the interaction term between cash flow and financial development. This conditions,
implies that financial development lowers the dependence of firms on their internal finance.
This result is driven by the reduced financial constraints faced by firms when there is a
constraints,
development in financial markets that reduces the frictions arising from asymmetric cash flow
information, agency problems and transaction costs.
This negative interaction coefficient supports the hypothesized negative relationship
between financial development and ICF sensitivity. It points out that financial development
relaxes the connection between internal resources and firm investment. The development in
the financial system enhances firms’ capability of accessing external finance and therefore,
the reliance on internal cash flow for undertaking the investment will be reduced.
The association between financial development and external financing constraints is
supported by several arguments. First, the expansion of the financial system increases the
amount of resources a firm may dispose of to undertake profitable investment opportunities.
Love (2003) argues that financial development alleviates financing constraints by reducing
information asymmetries and contracting imperfections, which improves capital allocation.
Second, financial development increases the stock market liquidity. Therefore, it will be
relatively inexpensive to trade financial instruments and little uncertainty about the timing
and settlement of those trades will occur. As stock market transaction costs fall, firms may
have the better access to the external finance (Levine, 1997). Third, as suggested by Tran and
Le (2017), improved financial market conditions can affect risk-shifting behavior through
resultant changes in internal funds that affect firms’ access to external finance.
If financial development reduces constraints, the interaction coefficient between cash flow
and financial development would be higher in financially weak firms. This is because
financial development reduces the external borrowing constraints and thus, constrained
firms benefit more from financial development.
As highlighted in Columns (5) and (6) of Table 5, the interaction coefficient between cash
flow and FIN is negative and significant for the two groups and is a lot larger for financially
weak firms. This indicates that the more financially constrained firms experience greater
effects from financial development compared with their less constrained counterparts, which
already have less difficulty in finding external funding sources. Since constrained firms are
more likely to suffer from financing constraints, the magnitude of financial development on
the sensitivity of investment to availability of internal funds is more obvious in these firms
than in less constrained ones.
4.3.3 Financial reform and ICF sensitivity. The last three Columns of Table 5 present the
results of the specifications with interaction of cash flow and financial reform. REF stands for
the dummy variable representing financial reform (after reform 5 1, before reform 5 0). The
results show a negative but not significant interaction coefficient between financial and cash
flow. This implies that KSA firms do not profit from opportunities provided by the financial
reform implemented in mid-2015. However, these results must be interpreted with care as the
period post-reform is so short to observe firms’ reactions and their financial behavior
adjustment. Financial reforms may take time to confer benefits and our data sample may not
be sufficiently long to account for this delayed effect. Further, to improve resource allocation,
financial reforms must be initiated with other measures. Financial authorities may put in
place measures to move away from a controlled economy and an administratively managed
financial system towards an open and market oriented system with a reduced direct
involvement of the state.
4.3.4 The effect of financial crisis on ICF sensitivity. The study examines the influence of
financial crisis on the sensitivity of investment to cash flows by estimating the model outlined
in Eqn (2). Several studies maintain that the recent financial crisis covered the period from
2007 to 2009 (Duchin et al., 2010; Almeida et al., 2011; Kahle and Stulz, 2013), thus we also
JEAS choose the 2007–2009 period to capture this crisis. The estimation results are reported in
Table 6 (Columns (1), (2) and (3)).
Starting with the case of all firms, the results show that investment expenditures of firms
display a high sensitivity to cash flow in the crisis period. The coefficient associated with the
interaction term between cash flow and financial crisis is positive and significant suggesting
that financial crisis exacerbates the ICF sensitivity. This result supports H5 that financial
crisis increases the sensitivity of corporate investment to cash flow. Thus, owing to liquidity
constraints during times of financial crisis, firms will find it more difficult to access external
funds. The prevalence of financial market frictions due to financial crisis increases external
finance costs, which, in turn, considerably affects the financing choices of firms. As a result,
firms will be more reliant on internally generated funds for their investment projects. These
results are consistent with the argument that cash flows are more binding on investment
when capital market imperfections are likely to be more severe, which is expected to be the
case during a financial crisis period (Almeida et al., 2011; Drobetz et al., 2017).
The adverse effect of financial crisis is expected to be more pronounced for weak firms
than for healthy firms. Columns (2) and (3) of Table 6 report the regression results. As
shown in Table 6, the ICF sensitivity declines for both less constrained and more
constrained firms in the post-crisis period, and that the decline is significantly greater for
financially constrained firms. For more constrained firms, the coefficient associated with
interaction term between cash flow and financial crisis decreases from 0.751 (0.408 þ 0.343)
in the crisis period to 0.408 in the post-crisis period. Moving to less constrained firms, the
ICF sensitivity coefficient exhibits a decline from 0.417 (0.228 þ 0.189) in the crisis to 0.228
in the post-crisis period. These empirical findings align with the literature’s argument that
financially weak firms suffer more from the presence of constraints than financially healthy
firms. Duchin et al. (2010) argue that negative shocks to the supply of external finance might
hamper investment if firms lack sufficient financial slack to internally fund all profitable
investment opportunities. These effects are particularly severe in firms that face relatively
greater costs in raising external capital or relatively greater need to do so. Similarly,
Drobetz et al. (2017) suggest that when there is a major liquidity crisis, financially weak
firms will suffer more greatly in both their investment and their financing decisions. In
contrast, healthy firms appear to have built financial flexibility to withstand such a severe
crisis and protect their capital expenditures by accumulating significant amounts of cash
holdings.
The reported results support previous findings that firms are constrained in accessing
capital markets and that constrained firms have to focus more on internal financing and seem
to have increasing ICF sensitivity (Duchin et al., 2010; Almeida et al., 2011; Drobetz et al., 2017).
Another possible concern is that the results may reflect the liquidity shock occurred by oil
price. Concurrent with the global financial crisis and the weak global economy, the oil price
fell steeply until January 2009 before substantially rebounding over the next few years.
Consequently, due to oil price decline induced by financial crisis, the investment policy of
petrochemical firms may depend highly on internal fund. To address this issue, we estimate
Eqn (2) by considering the effect of the financial crisis on the relationship between investment
and cash flow for both petrochemical and non-petrochemical firms. Columns (4) and (5) of
Table 6 report the results. The coefficients on the interaction between financial crisis and cash
flow are all positive, showing that financial crisis deepens the dependence of both
petrochemical and non-petrochemical firms on their internal funds in financing new projects.
However, reported results show a large discrepancy between the two subsamples. As
highlighted in Table 6, petrochemical companies are more reliant on internally generated
funds while making investment decisions during the crisis period. Thus, to the extent that the
crisis resulted in a decreased oil price, the cash flow shock is more severe for petrochemical
firms. Consequently, they experience the higher ICF sensitivity.
 Full sample (1) Healthy (2) Weak (3) Petrochemical (4) Non-petroch. (5)

(I/K)it1 0.312 (8.52)*** 0.246 (6.42)*** 0.196 (3.08)*** 0.184 (4.12)*** 0.208 (2.52)**
(CF/K)it 0.339 (1.92)* 0.228 (1.99)** 0.408 (2.32)** 0.148 (1.78)* 0.194 (1.89)*
(CF/K)it 3 CRISISt 0.312 (4.02)*** 0.189 (1.71)* 0.343 (2.44)** 0.536 (2.92)*** 0.376 (2.23)**
(S/K)it 0.129 (2.26)** 0.284 (3.22)*** 0.082 (1.68)* 0.346 (4.61)*** 0.174 (2.32)**
CRISISt 0.054 (2.66)*** 0.020 (0.66) 0.042 (1.66)* 0.004 (0.14) 0.032 (1.66)*
Constant 0.013 (3.06)*** 0.018 (2.46)** 0.032 (3.77)*** 0.022 (2.04)** 0.012 (3.12)***
Sargan test 0.74 0.64 0.36 0.85 0.21
AR test
H0: AR(1) 5 0 0.00 0.00 0.02 0.00 0.00
H0: AR(2) 5 0 0.36 0.24 0.16 0.58 0.28
Wald test 202.56 82.94 68.24 98.23 78.16
N 1,262 768 494 215 1,047
Note(s): This table displays results for GMM estimations of the equation in specification (2). Columns (1), (2) and (3) show results of the financial crisis effect on the ICF
sensitivity for the full sample, less constrained and more constrained firms, respectively. Columns (4) and (5) report results of the financial crisis effect on the ICF
sensitivity for the petrochemical and non-petrochemical firms, respectively. The full sample consists of 1,262 firm-years from KSA between 2007 and 2018. *, ** and ***
indicate significance at the 1%, 5% and 10% level, respectively
constraints,
conditions,

Estimation results of
cash flow

Table 6.
Financial

the impact of financial

crisis on ICF sensitivity
JEAS 4.4 The effect of firm characteristics (family control and group affiliation tests)
Ownership concentration and family control appear to be two most common features of
corporate ownership in KSA capital markets. According to Eulaiwi et al. (2016), the
concentration of family ownership is much higher in the KSA than in most developed
countries. Family ownership concentration is largely addressed in the literature as a
corporate governance mechanism. Prior studies suggest that high family ownership
increases the likelihood of power abuse and hurting non-family minority shareholders (e.g.
Maury, 2006; Eulaiwi et al., 2016).
On the other hand, as argued by Shleifer and Vishny (1997) and Bhabra et al. (2018), strong
corporate governance enhances management credibility in external capital markets and
hence reduces information asymmetry. Thus, strong-governance firms are more likely to be
financially unconstrained as opposed to weak governance firms. The implication is that KSA
family firms may face higher ICF sensitivity.
With regard to business group affiliation, existing literature argues that standalone firms
are more financially constrained than group affiliated firms. Hovakimian (2011) and Gupta
and Mahakud (2019) argue that managers of affiliated firms can rely on internal capital
markets as a source of liquidity for funding their available projects. Kumar and Ranjani
(2018) report evidence that standalone firms are more cash flow sensitive to investment in
comparison to group affiliated firms, highlighting both their strong dependence and scarcity
of internal funds for investment decisions.
This section considers the influence of family control and group affiliation on the
sensitivity of investment to cash flows by estimating the models outlined in Eqns (3) and (4).
The results presented in Table 7 show that family control has a positive effect on the ICF
sensitivity. This suggests that family control exacerbates the ICF sensitivity in KSA firms.
Family-controlled firms face costly external financing and consequently will be more
financially constrained. These results show support for the risk aversion hypothesis. Because
family managers invest their human capital in addition to financial capital in their firms, they
are more likely to be conservative in investments and the consequent use of their cash

Family control Group affiliation

(1) (2)

(I/K)it1 0.417 (9.57)*** 0.348 (8.96)***

(CF/K)it 0.457 (2.79)*** 0.604 (3.82)***
(CF/K)it 3 FAMi 0.171 (1.72)*
(CF/K)it 3 GROUPi 0.237 (2.18)**
(S/K)it 0.248 (3.12)*** 0.380 (3.77)***
FAMi 0.052 (0.88)
GROUPi 0.142 (1.98)**
Constant 0.037 (3.57) ***
0.057 (3.83)***
Sargan test 0.45 0.74
AR test
H0: AR(1) 5 0 0.00 0.00
H0: AR(2) 5 0 0.18 0.29
Wald test 166.24 172.84
Table 7. N 1,262 1,262
Impact of family Note(s): This table displays results for GMM estimations of the equations in specification (2) and (3). Column
control and business (1) shows results of the family control effect on the ICF sensitivity. Column (2) reports results of the effect of the
group affiliation on ICF affiliation to a business group on the ICF sensitivity. The full sample consists of 1,262 firm-years from KSA
sensitivity between 2007 and 2018. *, ** and *** indicate significance at the 1%, 5% and 10% level, respectively
cushion. Therefore, managers in such firms are more reluctant to access external markets and Financial
prefer to fund capital investments with internally generated funds (Bhabra et al., 2018). conditions,
Results in Table 7 (Columns (4), (5) and (6)) suggest that group affiliated firms are
significantly less investment-cash flow sensitive. This is consistent with previous studies’
constraints,
argument that group affiliated firms are generally less financially constraints due to the cash flow
existence of internal capital market. Therefore, they can easily finance internally compared
with standalone firms (Hovakimian, 2011; Gupta and Mahakud, 2019).

5. Conclusion
The sensitivity of investment to internal finance is one of the most debatable topics in
corporate finance literature. Empirical studies of investment in the presence of financing
frictions have provided mixed results regarding whether or not more financially constrained
firms show higher or lower sensitivity of investment to cash flows.
This study extends previous literature by examining the effect of financial conditions on
investment-cash flow sensitivity for a panel of KSA firms. The empirical results provide
insights into our understanding of the investment decisions of firms operating in emerging
markets. Conclusions from this study can be summarized as follows. First, we find that
investment is strongly cash-flow sensitive in KSA context. This reflects the higher market
imperfections in Saudi stock market. Additionally, we find that more financially constrained
firms exhibit significantly higher ICF sensitivity suggesting that these firms have limited
access to external funds. Therefore, they depend mainly on their internally generated funds to
finance corporate investments. Second, our evidence also reveals that better financial
conditions relax firms’ financing constraints. A decrease in interest rate reduces the credit
constraints faced by firms, and therefore weakens their dependence on internally generated
funds when undertaking new investment projects. Similarly, we find strong evidence that
financial development affects the financial constraints faced by the firms. The development
of financial markets weakens the effect of financial constraints on firm investment, and this
effect is considerably higher in the more financially constrained firms than in the less
constrained ones. Third, we find that KSA listed firms prefer internal rather than external
financing in the financial crisis period. In addition, consistent with a causal effect of a supply
shock, the decline is more prominent for firms that are financially constrained. This suggests
that when there is a major liquidity crisis, financially weak firms will suffer more greatly in
both their investment and their financing decisions.
Additional tests consistently demonstrate that family control exacerbates the ICF
sensitivity of KSA listed firms. Further, when we split our sample according to business
group, we find that affiliated firms are less investment-cash flow sensitive as they benefit
from internal capital market.
Subject to the above caveats, we can draw some policy implications based on the results
obtained in this paper. First, policymakers should pay attention to the importance of
policymaking based on the monetary demand of microeconomic entities. In monetary
contraction periods, firms face greater challenges in accessing external finance. These firms
are likely to experience under-investment, which at a macro level would translate into lower
investments and economic growth for the country. Second, policymakers are encouraged to
implement complementary measures that, coupled with existing financial reforms, may
promote efficiency, competitiveness, and transparency in firms’ operations. Finally,
managers and investors should consider financial structure and condition as important
factors in their investment decision.
The policy implications of the study open a new channel to explore the effects of nominal
aggregates on real variables. We suggest that contractionary monetary policy, poor financial
development and liquidity crisis, through the reduction of external financing, reinforce the
JEAS dependence of firms on internal funding and thus reduce the demand for productive capital
inputs. Future work includes extending this study to investigate the effects of
macroeconomic factors on corporate investment efficiency. In addition, the study is limited
to KSA listed non-financial firms. However, a large number of private firms are not taken into
account in this study. Future research can be conducted on the private firms in developing
economies. Such studies can further validate the effect of financial conditions on the ICF
sensitivity and derive managerial implications for a large spectrum of firms in different
developing countries.

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Corresponding author
Moncef Guizani can be contacted at: guizani_m@yahoo.fr

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