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Impact of
The impact of financial and financial and
economic crisis on leverage: the economic crisis

case of Icelandic private firms

Twahir Khalfan and Stefan Wendt 297
Reykjavik University, Reykjavik, Iceland
Received 16 January 2019
Revised 24 May 2019
21 October 2019
Abstract Accepted 23 October 2019
Purpose – The purpose of this paper is to provide empirical insight into the impact of a financial crisis on
capital structure of private firms. Specifically, the authors use the example of the systemic Icelandic financial
crisis from 2008 to 2010 and analyze the influence of internally generated funds on leverage during the
financial crisis compared to the non-crisis period.
Design/methodology/approach – The authors use a fixed-effects dynamic model to examine the impact of
internally generated funds – measured as cash flow – with a data set that includes non-listed Icelandic firms.
In addition, generalized method of moments is used to address potential endogeneity issues.
Findings – The authors find that internally generated funds have a different effect on capital structure
during the financial crisis compared to the non-crisis period. While cash flow has an overall negative
association with leverage, a positive relationship appears to exist during the crisis. However, when analyzing
changes in cash flow from one year to the other, the sample firms appear to rely more on internally generated
funds to adjust leverage during the financial crisis than in the non-crisis period.
Originality/value – Analyzing the extreme case of the Icelandic financial crisis allows us to shed light on
capital structure effects in situations when both debt financing and internal financing opportunities are
heavily curtailed.
Keywords Financial crisis, Leverage, Capital structure, Icelandic private firms, Internally generated funds
Paper type Research paper

1. Introduction
Flannery and Rangan (2006) and Strebulaev (2007) propose that highly leveraged firms
use internally generated funds to adjust debt ratios when external financing is largely
constrained. In a similar vein, Akbar et al. (2013) find that financing policies of private
firms are susceptible to variations in the supply of credit, in particular, when these firms
encounter high costs of obtaining external capital during the financial crisis. However,
Buch and Neugebauer (2011) show that a financial crisis negatively affects firms’ cash
flow generation, which in turn reduces firms’ opportunities to adjust their levels
of leverage.
The availability of internally generated funds is very important during and
immediately after a financial crisis that severely negatively influences banks and creates
distress to the overall stability of the banking system (Blank et al., 2009). According to
Brunnermeier (2009) and Shleifer and Vishny (2010), the diminishing supply of debt
financing due to credit rationing during the global financial crisis caused the transmission
of adverse effects from banks to the real economy. A similar effect is also shown by
Claessens et al. (2003) who reveal that the influence of a financial crisis on the real
economy through leverage is largely reflected by the levels of corporate financial distress
and bankruptcies.

JEL Classification — G31, G32, G34 International Journal of Managerial

The authors are very grateful to Jan Bartholdy from Aarhus University, Denmark and Jon Thor Finance
Vol. 16 No. 3, 2020
Sturluson from Reykjavik University, Iceland for valuable comments and suggestions. The authors pp. 297-315
also thank seminar participants at Bamberg University, Germany and Reykjavik University, Iceland. © Emerald Publishing Limited
1743-9132
All remaining errors are of the authors’ own. DOI 10.1108/IJMF-01-2019-0019
IJMF We contribute to the discussion of the impact of a financial crisis on capital structure
16,3 and, in particular, on the use of internally generate funds to adjust leverage with an analysis
in the context of the 2008–2010 financial and economic crisis in Iceland. This crisis led to a
systemic failure of the financial sector and stock market in Iceland, including bankruptcy of
the main banks, and a severe shock to the real economy (Sigurjónsson and Mixa, 2011;
Magnússon, 2016). Considering that bank debt is the main external financing source of
298 Icelandic firms and that firms’ activities in the real economy considerably impact internal
financing opportunities, the question arises as to how the 2008–2010 crisis influenced the
access to capital and financing decisions in times of financial distress. This paper employs a
unique data set of 330 Icelandic non-listed small- and medium-sized enterprises (SMEs)
covering the period from 2006 to 2012 to address this question. Specifically, the paper
presents new insight into the consequences of a severe systemic financial crisis for capital
structure of private firms[1].
The Icelandic economy provides an interesting context to analyze the impact of a
financial crisis on the access to capital and managerial decisions in times of financial
distress that heavily affected the real economy and constrained private firms’
opportunities to generate both internal and external financing. During and after the
financial crisis, access to foreign capital was limited, because foreign investors found it
unattractive to invest in Iceland due to capital controls that were in place from 2008 to
2017[2]. When it comes to external sources of financing, most Icelandic firms depend
heavily on bank debt[3]. In this sense, they show a similar pattern as SMEs in other
countries and rely on banks as the leading source of external financing (e.g. Iturralde et al.,
2010; Petersen and Rajan, 1994).
Although Icelandic banks were recapitalized by the state and by pension funds to
preserve their ability to lend (Financial Supervisory Authority of Iceland, 2010), a large
number of highly leveraged private firms under high cross-ownership connection with
banks faced limited access to debt because of firms’ financial insolvency (Friðriksson,
2015). This study, therefore, focuses on private firms that are mainly relying on few
financial institutions as a primary source of external funding, which means that
the negative impact of the systemic failure of the financial sector should be much more
apparent among private firms than listed firms. Moreover, this study focuses on private
firms because only few firms were listed on the Icelandic stock exchange during and after
the financial crisis[4].
The main contribution of this study to the literature is the analysis of capital
structure in a situation in which bank debt as the leading source of external financing is
shortened by the collapse of the financial system and, simultaneously, the overall
economic crisis is drying up opportunities to internally generate funding. Moreover, this
paper contributes to the growing literature of capital structure in private firms (Brav,
2009; Goyal et al., 2011; Mateev et al., 2013), while most of the previous research on
determinants of capital structure focuses on listed firms (e.g. Rajan and Zingales, 1995;
Frank and Goyal, 2003).
This study examines in a fixed-effects model approach whether managers rely more
heavily on internally generated cash flows to decrease leverage during the financial crisis
compared to the period when the economy is recovering. Robustness checks are included to
account for effects of potential survivorship bias, and potential endogeneity issues between
internally generated funds and leverage are addressed using a Generalized Method of
Moments (GMM) approach.
This paper reveals that the impact of internally generated funding on leverage is
different during the financial crisis compared to the situation afterwards. Internally
generated funding in terms of cash flows has a negative impact on leverage during the full
observation period (2007–2012), but a positive influence during the financial crisis.
After the crisis, the sample firms encounter an increase in internally generated cash flows Impact of
and a substantial decrease in leverage. However, our results are not fully robust financial and
to alterations in the empirical model. We also find that an increase in cash flow from one economic crisis
year to the other during the crisis reduces leverage, whereas this relationship is
insignificant afterwards.
Beyond the results in the immediate context of the research question, the analysis
shows that larger firms largely avoid additional debt financing during the financial crisis. 299
The results also reveal a relationship between corporate size and reduction in leverage
during the financial crisis, but not afterwards. Working capital has a consistent and
negative relationship to leverage both during and after the financial crisis, while the extent
of tangible assets on the balance sheet has no association with leverage.
The paper is organized as follows. Section 2 provides an overview of related literature
and derives the hypotheses. Section 3 describes the data set and methodology and Section
4 presents the empirical results and discussion of the findings. Section 5 concludes.

2. Literature review and hypothesis development

A number of studies reveal high levels of debt across many private firms, typically
based on bank loans (Brav, 2009; Giannetti, 2003; Ortiz-Molina and Penas, 2008). In this
regard, Faulkender and Petersen (2006) and Keasey et al. (2015) highlight that
many private firms overly rely on bank lending due to better access to bank debt than to
public bond markets. Beck et al. (2008) and Bhaird and Lucey (2010) find that special
lending relationships with banks enhance the ability of private firms to access
debt financing.
The funds that are generated internally typically appear to be negatively related to
leverage when economic conditions are normal (Brav, 2009; Frank and Goyal, 2003;
Giannetti, 2003). Potential reasons include the thoughts underlying Myers and Majluf’s
(1984) pecking order proposition and particularly the high degree of information
asymmetry with regard to private firms, which makes external debt funding more costly.
Erkens et al. (2012) note that a financial crisis magnifies imperfect information between
creditors and shareholders, which makes monitoring by lenders even more difficult
and costly.
Moreover, as discussed in previous studies (e.g. Campello et al., 2010; Garcia-Appendini
and Montoriol-Garriga, 2013; Nguyen et al., 2015), the recent global financial crisis greatly
constrained corporate ability to raise debt in capital markets. Brunnermeier (2009) and
Ivashina and Scharfstein (2010) find that the influence on leverage is predominantly
noticeable when financial institutions within bank-centered markets incur heavy losses
during a severe systemic financial crisis.
The turmoil in the Icelandic financial system from 2008 to 2010 curtailed banks’ access to
external funding from foreign capital markets, which in turn restricted firms’ ability to obtain
debt from these banks (Baldursson and Portes, 2013; Sigurgeirsdottir and Wade, 2015).
This means that debt, as external financing opportunity is hardly accessible for many firms,
which makes internal funds even more important during the crisis period. Therefore, it is
expected that the linkage between internally generated capital and leverage is affected by the
financial crisis:
H1. Internally generated funds influence leverage differently during the financial crisis
compared to the non-crisis period.
Antoniou et al. (2008) and Hennessy and Whited (2005) identify that market conditions in
which firms operate heavily influence leverage. Faulkender et al. (2012), Kayhan and Titman
(2007) and Leary and Roberts (2005) propose that it is valuable for highly leveraged firms to
use internally generated funds to rebalance capital structure and reduce debt when they
IJMF deviate from optimal ratios. Borensztein and Lee (2002) argue that firms with bank
16,3 affiliations encounter higher leverage contraction during a financial crisis because they lose
preferential access to the credit which they usually enjoyed in the pre-crisis period. In a
similar vein, Hempell and Sorensen (2010) and Hyun and Rhee (2011) present empirical
evidence showing that the 2008 global financial crisis reduced banks’ liquidity positions and
access to outside financing, which inhibited their ability and willingness to supply loans. On
300 the other hand, Kanaya and Woo (2000) report that highly leveraged bank-centered firms
have a lower incentive to use internally generated funds to reduce debt during the financial
crisis as they anticipate lenient debt restructuring. In this sense, Iyer et al. (2014) explain that
in addition to credit rationing, banks tend to force firms to bring down debt during the
financial crisis.
Consistent with the pecking order capital structure proposition, Shleifer and
Vishny (2010) reveal that the tendency to rely on internally generated income as a
major source of financing is more noticeable during the financial crisis than afterwards.
Firms that mainly rely on bank lending for external capital are usually required to reduce
their leverage in order to be able to access new debt during financial crisis (Chava and
Purnanandam, 2011).
Beyond a negative association between the level of internally generated funds and
leverage, we expect that Icelandic private firms reflect changes in internally generated funds
from one year to the other more strongly in changes in leverage during the financial crisis
than during the non-crisis period. On the one hand, this means that there is more incentive to
use an increase in internally generated funds from one year to the other to reduce leverage,
On the other hand, this also means that a reduction in internally generated funds more
strongly translates into an increase in leverage:
H2. An increase in internally generated funds from one year to the other has a greater
impact on leverage during the financial crisis than in the non-crisis period.

3. Data set and methodology

3.1 Data set
The data set consists of items included in firms’ annual income statements, balance sheets
and credit status and has been provided by Creditinfo, an independent organization that
collects financial information of private firms. Regardless of ownership type and
irrespective of whether they have any taxable income or not, Icelandic limited firms have a
legal obligation to submit audited annual financial reports to the Tax Authority (PWC,
2014). The initial data set covers the 400 largest Icelandic private firms from all mainstream
industries in the period from 2006 to 2012. The sample excludes government-owned firms,
largely because their financing policies potentially incorporate political objectives that
might contradict the maximization of corporate value. Furthermore, financial firms are
excluded because their capital structure decisions and regulations are fundamentally
different from industrial firms[5].
The final data set contains 330 private firms with annual observations from 2006 to
2012. The fiscal year for these firms is equal to the calendar year. The crisis period covers
the years 2008–2010, whereas 2011 and 2012 represent the recovery period. As an
indication of the impact of the financial crisis on the overall economy, Figure 1 displays
negative growth rates of annual gross domestic product (GDP) in 2009 and 2010 and signs
of recovery as of 2011.
Figure 2 illustrates a dramatic decline in stock market capitalization as percentage of
GDP from 2007 to 2009 and a relatively stable pattern thereafter. This also indicates an
unfavorable environment for new external equity financing through initial public offerings.
 12 Impact of
10 financial and
8 economic crisis
% GDP Growth rate

2
301
0 Figure 1.
2005 2006 2007 2008 2009 2010 2011 2012 2013 Annual percentage
–2
Year growth rate of the
Icelandic GDP
–4
at market prices
–6 based on constant
local currency
Source: World Bank (2014)

250
Stock Market capitalization as % GDP

200

150

100

50

Figure 2.
0 Icelandic stock market
2005 2006 2007 2008 2009 2010 2011 2012 2013 capitalization as
Year percentage of
annual GDP
Source: World Bank (2014)

3.2 Variable definition

Leverage and internally generated funds. In a similar manner as in, e.g., Giannetti (2003),
Frank and Goyal (2009) and Margaritis and Psillaki (2010), leverage is defined as book value
of total debt divided by book value of total assets. As measure of internally generated funds,
the paper uses cash flows determined as net income plus depreciation divided by book value
of total assets.
Control variables. Frank and Goyal (2009) and Hol and Van Der Wijst (2008) show that
various firm-specific characteristics influence leverage. More specifically, we control for the
financial standing in a similar way as Hoshi et al. (1990) using the dummy variable
F_Distress that takes a value of 1 if the debt coverage ratio, defined as net income over
interest expenses, is below 1 and 0 otherwise. The analysis also controls for the book value
of tangible assets scaled by the book value of total assets (Tangibility) because as collateral
tangible assets are important to access debt financing (Margaritis and Psillaki, 2010).
In particular, during the financial crisis, tangible assets are expected to have a positive link
with leverage (Antoniou et al., 2008).
IJMF Another variable, Size as the log book value of total assets is included to control for a
16,3 potential negative relationship between size and leverage because large firms are assumed
to have more capability to use internally generated capital for financing purposes (Giannetti,
2003). In addition, the analysis of this paper controls for working capital, defined as current
assets minus current liabilities and scaled by the book value of total assets, as measure of
liquidity to reflect firms’ financial standing.
302
3.3 Descriptive statistics
At some point during the period from 2006 to 2012, 85 percent of the sample firms were
under financial distress as they lacked sufficient income to meet debt obligations in the next
financial year (see Table AI). Around 41 percent of the sample firms even experienced
financial distress for at least three out of the seven observation years. This clearly shows the
extensive nature of the financial and economic crisis in Iceland.
Table I presents annual descriptive statistics for all variables and each year from 2006 to
2012. Average leverage levels are highest with 72 percent in 2008, followed by a
considerable decline to the lowest level of 44 percent in 2012. Internally generated funds
measured as cash flow over total assets are highest in the year 2006 with a value of 0.12 and
lowest in 2008 with a value of −0.13; in subsequent years, cash flow levels improved
considerably but did not reach pre-crisis levels within the observation period.
The values for the variable F_Distress indicate that 36 percent of the sample firms
were financially distressed in the year 2006, while in the year 2008 about 62 percent of the
firms were financially distressed. The size of the sample firms based on total assets was
largest before the financial crisis and decreases until 2008; afterwards there is no clear
trend in firm size. The level of tangible assets has been relatively stable until 2009,
but increases between 2009 and 2010 by approximately 5 percentage points to a new level
that remains largely unchanged until 2012. Working capital relative to total assets
drops from of 6 percent in 2006 to −27 percent in 2010 and fluctuates around zero in the
other years.
Table II provides correlation coefficients among the explanatory variables used in the
regression analysis. The correlation between the variables is largely in line with
reasonable expectations. Cash flow is considerably negatively correlated with financial
distress (−0.379), but highly positively correlated with working capital (0.620).
Accordingly, working capital is significantly negatively correlated with financial
distress. The variable for tangibility of assets is slightly positively correlated with
financial distress and working capital, but more positively correlated with firm size. Size
and working capital are somewhat positively correlated. All these correlation coefficients
are statistically significant at least at the 5 percent level. The other correlation coefficients
are statistically insignificant. Given the relatively high correlation coefficients among
some of the explanatory variables, we estimate variance inflation factors (VIF) to examine
the extent of multicollinearity. However, as all VIFs are lower than 10, we do not expect
substantial multicollinearity.
Table III reports descriptive results for leverage, cash flow and the control variables both
during the crisis period (2008–2010) and during the remaining years. During the financial
crisis, the average leverage ratio is 64 percent compared to a leverage ratio of 58 percent in
non-crisis years, the difference being statistically significant at the 1 percent level. The
average cash flow over total assets is negative (−0.027) during the financial crisis but
positive in the remaining years (0.093). Again, the difference is statistically significant at the
1 percent level. This suggests that the financial crisis substantially reduced or even
eliminated internal financing opportunities.
As anticipated, more firms are in financial distress during the financial crisis than in the
other years. The level of tangible assets is slightly lower during the financial crisis than in
Variable 2006 2007 2008 2009 2010 2011 2012
Impact of
financial and
Leverage economic crisis
Mean 0.691 0.662 0.724 0.698 0.473 0.450 0.440
Maximum 0.930 0.830 0.861 0.790 0.631 0.603 0.635
Minimum 0.351 0.409 0.371 0.308 0.340 0.393 0.258
SD 1.234 1.347 3.132 2.495 1.092 1.426 0.972
303
Cash flow
Mean 0.123 0.101 −0.125 0.002 0.044 0.067 0.065
Maximum 0.375 0.650 0.343 0.263 0.497 0.491 0.510
Minimum 0.105 0.065 −0.256 0.053 0.028 0.106 0.178
SD 0.929 0.121 1.392 0.738 0.153 0.151 0.350
Tangibility
Mean 0.268 0.273 0.266 0.273 0.322 0.324 0.336
Maximum 0.963 0.835 0.423 0.495 0.510 0.631 0.683
Minimum 0.435 0.486 0.127 0.130 0.344 0.293 0.345
SD 1.234 1.347 2.132 1.495 1.092 1.426 0.872
F_Distress
Mean 0.362 0.423 0.620 0.553 0.505 0.440 0.372
Maximum 1.000 1.000 1.000 1.000 1.000 1.000 1.000
Minimum 0.000 0.000 0.000 0.000 0.000 0.000 0.000
SD 0.355 0.301 0.295 0.250 0.210 0.195 0.179
Size (MM)
Mean 68,226 66,630 53,632 62,544 61,852 57,754 53,524
Maximum 108,493 85,598 68,632 76,954 79,080 77,783 75,805
Minimum 58,513 52,630 28,150 32,531 41,290 36,754 35,240
SD 17.396 16.557 9.530 13.303 8.671 9.861 10.050
Working capital
Mean 0.063 −0.009 −0.023 −0.009 −0.273 0.009 −0.025
Maximum 0.250 0.181 0.104 0.117 0.286 0.350 0.379
Minimum 0.015 −0.082 −0.189 −0.102 −0.378 −0.085 −0.264
SD 1.672 1.179 0.645 3.598 5.684 7.648 8.314
Observations 328 320 294 285 268 256 233
Notes: This table provides descriptive statistics for each variable and the number of annual observations.
The sample contains 330 of the largest 400 Icelandic private firms from 2006 to 2012. Leverage is defined as
long-term debt plus short-term debt over book value of total assets. Cash flow is net income plus depre-
ciation over book value of total assets. F_Distress is a dummy variable taking a value of 1 for debt coverage
ratios below 1 and 0 otherwise. Tangibility is the book value of tangible assets over book value of total Table I.
assets. Size is the log value of the book value of total assets. Working capital is calculated as current assets Descriptive statistics
minus current liabilities scaled to book value of total assets. The last row displays the number of for the years
observations for each year 2006–2012

other years, the difference being statistically significant at the 10 percent level. However, the
differences in size and working capital between the crisis period and the other years are
not statistically significant. Still, the crisis might have influenced size and working capital in
single years as indicated in Table I, the effect, however, disappears when aggregating the
results to only two sub-periods.

3.4 The model

To estimate the effect of the financial crisis on the impact of internally generated funds on
leverage, the paper uses a dynamic panel model based on Fischer et al. (1989) and Flannery and
IJMF Rangan (2006). The model specification includes previous year leverage as explanatory
16,3 variable to incorporate the dynamics of debt and capital structure. It tests whether the effect of
cash flows on leverage differs between the financial crisis and afterwards:

Leveragei;t ¼ aþb1 UCash Flowi;t þb2 UCash Flowi;t UDCrisis þl1 ULeveragei;t1
304
þl2 ULeveragei;t1 UDCrisis þb3 UXi;t þ b4 UXi;t UDCrisis þgUFE þei;t ; (1)
where Leverage is total debt (short-term plus long-term debt) over total assets of firm i at
time t; Cash Flow is net income plus depreciation divided by total assets; DCrisis is a dummy
variable taking a value of 1 for observations during the financial crisis (2008–2010)
and 0 otherwise; Cash Flow·DCrisis is the interaction term that measures the impact of cash
flows during a financial crisis; λ is the adjustment speed coefficient on lagged leverage; X
is a vector of control variables as described in Section 3.2; FE represents the firm fixed
effects; and e is the error term. The estimates are based on heteroskedasticity-consistent
standard errors with t-statistics corrected for clustering at time and industry levels
(Petersen, 2009).
Additionally, we analyze if an increase (decrease) in cash flow induces a larger
reduction (increase) of leverage for sample firms during the financial crisis compared
to afterwards. This analysis applies a model based on, e.g., Blouin and Krull (2009),

Cash flow F_Distress Tangibility Size Working capital

Cash flow 1.000

F_Distress −0.379*** 1.000
Tangibility 0.028 0.066** 1.000
Size −0.004 0.043 0.140*** 1.000
Table II. Working capital 0.620*** −0.335*** 0.059** 0.076*** 1.000
Correlation between Notes: This table reports correlation coefficients for our explanatory variables for 330 of the largest 400
explanatory variables Icelandic private firms. The definitions of variables are as given in Table I and Section 3.2. *,**,***Statistically
from 2006 to 2012 significant at 10, 5, and 1 percent levels, respectively

Variable During the financial crisis Without financial crisis Difference

Leverage 0.636 [847] 0.577 [1,137] 0.059***

Cash flow −0.029 [834] 0.093 [1,127] −0.122***
F_Distress 0.560 [673] 0.399 [887] 0.161***
Tangibility 0.285 [810] 0.295 [1,072] −0.010*
Size (MM) 59.218 [849] 62.409 [1,141] −3.191
Working capital −0.079 [752] 0.018 [296] −0.097
Notes: This table provides descriptive statistics for the impact of the financial crisis on firm-specific char-
Table III. acteristics. The sample contains 330 of the largest 400 Icelandic private firms from 2006 to 2012. The column
Descriptive statistics “During the financial crisis” stands for observations during the crisis period 2008–2010, the column “Without
for the impact of the financial crisis” includes the remaining years. The last column contains the difference between crisis period and
financial crisis on non-crisis period and corresponding t-test results. Variable definitions are as explained in Table I and Section 3.2.
firm-specific We report mean values. The numbers of observations are in square brackets. *,**,***Statistical significant
characteristics at 10, 5 and 1 percent levels, respectively
Hribar et al. (2006) and Liu and Swanson (2016) who use a similar approach in the context Impact of
of various financial concepts: financial and
DDebt=Total Assetsi;t1 ¼ aþb1 UDCash Flow=Total Assetsi;t1 þb2 UX i;t þei;t ; (2) economic crisis
where Δ is the change in the variable from the previous year (t−1) to the current year (t)
and Debt is the sum of long-term and short-term debt. Total Assets is the book value of
total assets. 305
4. Empirical findings
4.1 The financial crisis, internally generated funds and leverage
Table IV reports the regression results based on Equation (1), which focuses on H1 and
analyzes the impact of the financial crisis on the relationship between cash flow as measure
of internally generated funds and leverage.
When applying the most basic model specification as reported in the first results column
in Table IV, cash flow has a negative and highly statistically significant impact on leverage
for the full sample period. The coefficient for interaction term between crisis period and cash
flow is statistically insignificant which would imply that the financial crisis does not
influence the relationship between cash flow and leverage. This result indicates that firms
reduce leverage if sufficient internal funding is generated which also supports the pecking
order theory, which states that firms should use internal financing opportunities before
financing with debt.
The negative relationship between cash flow and leverage is even more obvious
when including previous-year leverage and all control variables. In the full regression
model, which is displayed in the last column of Table IV, the coefficient for the interaction
term between cash flow and the crisis period is positive and statistically significant at the
1 percent level. Relatively speaking, this means that during the financial crisis cash

Variable (1) (2) (3)

Cash flow −0.081 (−3.081)*** −1.571 (−2.611)*** −0.456 (−2.383)**

Dcrisis ×Cash flow −0.121 (−0.319) 0.342 (0.275) 0.970 (3.517)***
Leveraget−1 0.602 (6.000)*** −0.331 (−2.183)**
Dcrisis ×Leveraget−1 −0.531 (−2.937)*** −0.465 (−2.945)***
F_Distress 0.276 (2.326)***
D crisis
×F_Distress −0.574 (−3.679)***
Tangibility −0.508 (−1.324)
Dcrisis × Tangibility 0.259 (0.723)
Size −0.101 (−1.380)
D crisis
×Size 0.067 (6.233)***
Working capital −0.756 (−3.154)***
Dcrisis ×Working capital 0.246 (0.449)
Fixed firm effects Yes Yes Yes
Adjusted R2 0.657 0.694 0.860
Observations 1,317 1,317 805
Notes: This table provides the estimates of the effect of internally generated cash flow on leverage. The sample
contains 330 of the largest 400 Icelandic private firms from 2007 to 2012. Leverage is the dependent variable Table IV.
defined as total debt over total assets. Dcrisis is a dummy variable taking a value of 1 for observations during the The impact of the
financial crisis (2008–2010) and 0 otherwise. The definitions of the independent variables are as given in Table I financial crisis
and Section 3.2. Not reported is the intercept term. In parentheses, we report t-values calculated using robust on the relationship
standard errors corrected for clustering at time and industry levels. *,**,***Statistically significant at 10, 5, and between cash flow
1 percent levels, respectively and leverage
IJMF flow has a positive impact on leverage. Given the size of the coefficient for the interaction
16,3 term, this positive impact even appears to overcompensate the overall negative effect of
cash flow on leverage. These findings support the first hypothesis, which proposes a
different impact of cash flow on leverage during the financial crisis compared to the
non-crisis period.
In the full regression model, previous-year leverage has a negative influence on
306 current-year leverage, an effect which is even amplified during the financial crisis.
With respect to control variables, financial distress is positively connected with leverage,
which in itself is not surprising, but simply reflects how both variables are defined.
However, the coefficient for the interaction term between financial distress and crisis
period has a negative association with leverage. Given our approach, however, we cannot
disentangle potential reasons for the effect, such as increased restructuring efforts during
the crisis period.
Tangible assets do not have a statistically significant impact on leverage. Contrary to
trade-off theory, this indicates that firms do not use or are not able to use tangible assets as
collateral to access more debt financing neither during the crisis nor in the non-crisis period.
This means that our evidence is not in line with Giannetti (2003) and Antoniou et al. (2008)
who analyze this relationship under normal economic conditions. Size has an insignificant
effect on leverage. During the crisis, however, larger firms appear to have slightly larger
leverage levels. Working capital has a statistically significant and negative association with
leverage which indicates that firms with more liquidity (i.e. more working capital) are also
less leveraged, i.e. financially more healthy in both measures. The financial crisis does not
significantly influence this relationship.
Table V presents the estimates for the regression analysis based on Equation (2).
Considering potential credit rationing during the financial crisis, this analysis addresses
whether an increase in cash flow results in a stronger reduction of leverage during the crisis
than in the non-crisis period as indicated in H2. We run separate regressions for the crisis
period and the non-crisis period. The results for the crisis period in Columns (1) and (2) of
Table V illustrate that the larger the increase in cash flow from the previous to the current

During the financial crisis After the financial crisis

Variable (1) (2) (3) (4)

ΔCash flow/T.Assetst-1 −0.758 (−2.574)** −0.847 (−2.241)** −0.191 (−1.448) −0.221 (−1.642)
F_Distress −0.023 (−0.167) −0.064 (−1.546)
Tangibility/T.Assetst−1 0.296 (1.412) 0.076 (1.546)
Size (log of T.Assetst−1) −0.054 (−0.826) 0.016 (1.915)*
Working capital/T.Assetst−1 0.174 (3.742)*** 0.033 (1.924)*
Time dummies Yes Yes Yes Yes
Industry dummies Yes Yes Yes Yes
Adjusted R2 0.492 0.564 0.157 0.208
Observation 742 562 729 525
Notes: This table provides the results for the effect of changes in internally generated cash flows on leverage.
The sample contains 330 of the largest 400 Icelandic private firms from 2007 to 2012. The columns marked
Table V. “During the financial crisis” include observations from 2008 to 2010 and the columns marked “After the
The effect of financial crisis” include observations in 2011 and 2012. Δ is the change in the variable from previous to
internally generated current year. ΔDebt/T.Assetst−1 is the dependent variable defined as change in total debt over total assets. T.
funds on the change Assets represents the total book value of assets. The definitions of the independent variables are as given in
in leverage levels Table I and Section 3.2. Not reported is the intercept term. In parentheses, we report t-values calculated using
during and after the robust standard errors corrected for clustering at time and industry levels. *,**,***Statistically significant at
financial crisis 10, 5 and 1 percent levels, respectively
year, the larger the reduction of leverage. This result is statistically significant at the 5 Impact of
percent level. After the financial crisis (Columns (3) and (4) of Table V ), however, there is no financial and
statistically significant effect. In line with H2, these results indicate that in a period when economic crisis
debt financing is constraint and informational asymmetries are high, firms rely on internally
generated funds to decrease leverage, while this is not the case in a non-crisis period. This
also means, however, that a decline in cash flow (or even negative cash flow) during the
crisis translates into an increase in leverage due to the lack of opportunities to make capital 307
structure adjustment via changes in external financing.
Regarding the control variables, only size and working capital appear to have different
effects on leverage during the crisis compared to the non-crisis period. Although size is
statistically insignificant during the crisis, it has a positive impact on changes in leverage
afterwards with statistical significance at the 10 percent level. This implies that after the
financial crisis larger firms are associated with a greater increase in leverage than smaller
firms, which might reflect better access to debt financing for larger firms after the financial
crisis. Working capital is positively associated with changes in leverage both in the crisis
and the non-crisis period; the effect, however, is larger during the financial crisis, which
might reflect that during the crisis period, banks are only willing to provide more debt to
firms with higher liquidity levels.

4.2 Robustness checks

The first robustness check considers that the results of our analysis might be affected by the
fact that numerous firms have dropped from the sample due to liquidation during
the observation period and in particular as result of the financial crisis. To mitigate such a
bias, we re-run the regression based on Equation (1) for firms with observations throughout
the full sample period. The results of the robustness check as included in Table VI are only
partially consistent with the findings in Table IV. Without including control variables, cash

Variable (1) (2) (3)

Cash flow −0.101 (−2.175)** −0.082 (−2.138)** 0.015 (0.351)

Dcrisis ×cash flow 0.034 (0.643) 0.006 (1.006) −0.121 (−2.417)**
Leveraget-1 0.420 (9.461)*** 0.470 (11.703)***
Dcrisis ×Leveraget-1 0.014 (0.808) −0.167 (−3.817)***
F_Distress −0.086 (−3.354)***
Dcrisis ×F_Distress −0.001 (−0.301)
Tangibility −0.151 (−2.321)**
Dcrisis ×Tangibility 0.108 (2.263)**
Size 0.045 (4.244)***
D crisis
×Size 0.010 (3.102)***
Working capital −0.046 (−0.829)
Dcrisis ×Working capital −0.017 (−0.908)
Fixed firm effects Yes Yes Yes
Adjusted R2 0.629 0.645 0.656
Observations 1,209 1,209 903
Table VI.
Notes: This table provides the estimates of the effect of internally generated cash flow on leverage. The The impact of the
sample contains 252 of the largest 400 Icelandic firms with complete observations in the years 2006–2012. financial crisis on the
Leverage is the dependent variable defined as total debt over total assets. Dcrisis is a dummy variable taking a relationship between
value of 1 for observations during the financial crisis (2008–2010) and 0 otherwise. The definitions of all cash flow and
independent variables are as given in Table I and Section 3.2. Not reported is the intercept term. leverage for firms
In parentheses, we report t-values calculated using robust standard errors corrected for clustering at time and with full
industry levels. *,**,***Statistically significant at 10, 5 and 1 percent levels, respectively observation years
IJMF flow has a statistically significant and negative relationship with leverage, while the
16,3 interaction term for cash flow during the crisis period is insignificant which is consistent
with the previous results. When including the control variables, cash flow does not appear
to have an impact overall, but during the crisis, cash flow and leverage are negatively
related which is opposite to the findings in the original analysis but still reflecting that the
relationship differs between crisis and non-crisis period. This indicates that the positive
308 relationship between cash flow and leverage in the original analysis results from firms that
dropped out of the sample during the observation period, most likely because these firms
ceased operations.
Also with regard to the control variables, the robustness check reveals somewhat
different results compared to the analysis above, however, these differences can largely be
explained by the fact that the data set now only includes firms that survived the financial
crisis. Financial distress is negatively linked with leverage without any specific effect of
the crisis. Overall, tangible assets display a negative effect on leverage, but this impact is
significantly smaller during a financial crisis which indicates that more tangible
assets might at least to some degree improve debt financing opportunities during the
crisis. It appears that larger firms are associated with higher leverage, even slightly
more so during the financial crisis. Working capital, however, is insignificantly connected
with leverage. This robustness check indicates that the results at least to some degree
depend on the composition of the data set and on whether or not the firms survived the
financial crisis.
Another concern relates to potential endogeneity issues since leverage may influence
internally generated funds as highlighted by Flannery and Hankins (2013). To address this
methodological issue, we follow Arellano and Bover (1995) and Asongu and Nwachukwu
(2018) and use a GMM approach based on a two-step specification which applies forward
orthogonal deviations and controls for heteroscedasticity. The concern about simultaneity is
tackled by this estimation because it employs lagged differences of the regressors
as instruments in the level equation, while lagged levels of the regressors are used as
instrument in the differenced equation. Beyond tackling the issue of simultaneity, the GMM
estimation approach helps address endogeneity issues in all regressions by controlling for
time invariant omitted variables. The standard GMM equations in levels (3) and in
difference (4) are as follows:

Levi;t ¼ s0 þs1 Levi;tt þ s2 Cash Flowi;t þs3 DCrisis UCash Flowi;t

X
k
þ dh Xh;i;tt þZi þxt þei;t ; (3)
h¼1

   
Levi;t Levi;tt ¼ s1 Levi;tt Levi;t2t þs2 Cash Flowi;t Cash Flowi;tt
 
s3 DCrisis UCash Flowi;t DCrisis UCash Flowi;tt

X
k    
þ dh Xh;i;tt Xh;i;t2t þ ðxt xtt Þþ ei;t ei;tt ; (4)
h¼1

where, Lev is total debt (short-term plus long-term debt) over total assets of firm i at time t;
Cash Flow is net income plus depreciation divided by total assets; DCrisisCash Flow is an
interaction term that measures the impact of cash flows during the financial crisis; σo is a
constant; τ represents the coefficient of auto-regressive order; X is the vector of control
variables, ηi represents the firm-specific effects, ξt is the time specific constant and ei,t Impact of
is the error term. Since the estimation involves interactive regression, we include all financial and
constituent interactive variables in the specification similar to Asongu and De Moor (2017) economic crisis
and Brambor et al. (2006).
The first order auto correlation required to identify persistence in the dependent
variables is met based on the rule of thumb threshold of 0.800. In this regard, the correlation
between leverage and change in leverage which are dependent variables and the first lagged 309
values are 0.910 and 0.931, respectively. Another main requirement of using GMM
estimation is met because the cross-section data (number of companies ¼ 330) is higher than
the number of time series used in full time analysis (T ¼ 5). Finally, the analysis of the GMM
approach uses the Sargan and Hansen test for over-identifying restrictions and the validity
of exclusion restriction for instrument exogeneity.
Table VII presents the GMM estimates that largely confirm the results presented in
Tables IV and V regarding the connection between internally generated cash flows and
leverage. Despite the insignificant impact of cash flow on leverage for the full observation
period, the findings from GMM approach suggest that this influence is statistically
significant and positive during the financial crisis.

Variable OLS Model (1) GMM (2) GMM (3)

Leverage (t−1) 0.470*** (0.000) 0.767*** (0.000)

Change in Leverage (t-1) 0.826*** (0.000)
Cash flow −0.015 (0.919) −0.664* (0.081) −0.190*** (0.000)
Dcrisis ×Cash flow 0.121** (0.017) 1.278* (0.097) 0.197** (0.025)
Size 0.045*** (0.000) 0.089 (0.658) 0.016* (0.091)
Tangibility −0.151** (0.016) −0.137** (0.018) 0.061 (0.542)
Time effects Yes Yes
Net effects n/a n/a
AR(1) 0.074 0.024
AR(2) 0.432 0.567
Sargan OIR 0.648 0.156
Hansen OIR 0.205 0.523
DHT for instruments
(a) Instruments in levels H excluding group 0.510 0.718
Dif (null, H ¼ exogenous) 0.364 0.561
(b) IV (years, eq (diff )) H excluding group 0.257 0.718
Dif (null, H ¼ exogenous) 0.183 0.294
Fisher 4,946*** 3,125***
Instruments 34 34
Observations 903 903 903
Notes: This table displays the results of the dynamic model estimation. Full sample: 2006–2012; financial
crisis period: 2008–2010. Dependent variables in Models 1 and 2 are Leverage defined as total debt over total
assets and for Model 3 the dependent variable is Change in Leverage defined as change in total debt over total
assets between years. Dcrisis is a dummy variable taking a value of 1 for observations during the financial
crisis and 0 otherwise. The definitions of the independent variables are as given in Table I and Section 3.2.
Column 1 reports the estimates based on Ordinary Least Square (OLS) fixed effect model. Columns 2 and 3
report the estimates based on the generalized method of moments (GMM) approach. DHT: difference in
Hansen test for exogeneity of instruments’ subset. Dif: difference. OIR: over-identifying restriction test. The Table VII.
significance of italic values is twofold. (1) The significance of estimated coefficients, Hausman test and the Dynamic model for
Fisher statistics. (2) The failure to reject null hypothesis of: (a) no autocorrelation in the AR(1) and AR(2) tests the effect of cash flow
and (b) the validity of the instruments in the OIR and DHT tests. n/a: not applicable because of insignificant on leverage during
marginal effects. The mean value of internally generated cash flow is 4.684. *,**,***Statistically significant at and after the
the 10, 5, and 1 percent levels, respectively financial crisis
IJMF 4.3 Discussion of the findings
16,3 This paper employs the systemic financial crisis in Iceland from 2008 to 2010 to compare
the influence of internally generated funds on leverage of private firms during the crisis
with the influence during the non-crisis period. The results show that this relationship is
indeed different during the crisis compared to the non-crisis period. The negative
relationship between cash flow and leverage for the full observation period as identified
310 in the first step of the analysis seems intuitively understandable given that an increase in
internally generated funds increases (book value of ) equity (via retained earnings)
and might also allow to pay down debt, whereas a deterioration of internally generated
funds reduces equity. However, the financial crisis induces an opposite effect in the sense
of a positive relationship between cash flow and leverage during the financial crisis at
least in some of our model specifications. These results support the first hypothesis, which
indicates that cash flow affects leverage differently during the financial crisis compared to
the non-crisis period.
In this sense, the findings for the financial crisis contradict Myers and Majluf’s (1984)
pecking order proposition. It is also contrary to findings by Akbar et al. (2013) illustrating
that informational asymmetries associated with the 2008 global financial crisis led
financial profitability to be adversely related to leverage. Furthermore, Giannetti (2003)
provides conflicting evidence based on private firms during normal economic conditions,
as does Antoniou et al. (2008) for firms that mainly rely on bank financing.
The finding of a different impact of cash flow on leverage during the financial crisis
compared to the non-crisis period can be interpreted in the context of Strebulaev’s (2007)
suggestion that – on a relatively long time scale – capital market frictions cause internally
generated funds to impact leverage in a way that matches the predictions of both the
pecking order and the trade-off capital structure theories. Similarly, Hol and Van Der
Wijst (2008) conclude that for private firms, the relationship between financial
profitability and leverage is more complex than the proposition of these two leading
capital structure theories.
When looking into changes in cash flow from the previous to the current year instead of
levels of cash flow in specific year, this study finds that firms rely more heavily on internally
generated funds to reduce leverage during the financial crisis than in the non-crisis period.
In turn, however, these findings indicate that during the crisis a reduction in cash flow more
heavily turns into an increase in leverage than in other periods. Beyond the apparent lack of
opportunities to issue new equity during the financial crisis, highly leveraged firms, as in
our sample, have encountered credit rationing during the financial crisis and, thus,
the relationship between cash flow and leverage during the financial crisis differs from the
relationship in the non-crisis period. We cannot fully disentangle whether some portion of
the changes in leverage results from substantial write-down of assets. Toward the end of the
financial crisis, however, it seems that sample firms used the cash flows to reduce leverage
as the cash flow levels of the sample firms improved significantly by the end of year 2010.
However, the negative effect of a change in cash flows toward a change in leverage becomes
insignificant when credit supply and internally generated funding improve when the
economy was recovering.
We need to interpret our results with caution because the robustness check shows
that our results are not fully robust to alterations in our empirical models. The results
are consistent in the sense that the relationship between cash flow and leverage
differs between crisis and non-crisis period, but they are not fully consistent with regard
to the signs of the corresponding regression coefficient. This means that further research
should look more closely into further factors that potentially influence leverage and the
impact of internally generated funds on leverage. These factors include, e.g., the impact of
cross-ownership between firms and banks, long-term lending relationships with single
banks, asset write-down, internal governance characteristics and political and Impact of
supervisory pressure on both the financial and the corporate sectors during a severe financial and
crisis period. economic crisis

5. Conclusions
This study investigates the determinants of leverage among Icelandic private firms during
the collapse of the financial system and afterwards. The paper reveals that the financial and 311
economic crisis significantly influences the association between internally generated funds
and leverage. In this regard, it shows that the level of internally generated cash flows is
negatively linked with leverage, but the association is positive during a financial crisis. The
paper also finds that during a financial crisis when banks’ capability to lend is largely
reduced and the equity market is dried-up, changes in internally generated funds have a
stronger impact on leverage than in non-crisis years.
The results show that larger private firms tend to avoid debt financing and
reduce their leverage during the financial crisis. They also document an insignificant
association between tangible assets and leverage over the period of the financial crisis.
This is rather surprising, given that as collateral tangible assets usually play a crucial role
for access of debt. As our results appear to be not fully robust to alterations in the
empirical approach, additional analyses are necessary to fully disentangle the impact of
the crisis in the context of capital structure. Given the characteristics of the data set,
however, we need to leave the analysis of further factors that potentially influence the
relationship between internally generated funds and leverage during a financial crisis to
further research.

Notes
1. The contribution of SMEs in Iceland is greater than in most European Union (EU) countries
in terms of employment and value added. For instance, in 2012 Icelandic SMEs provided
71.7 percent of employment created by business sector compared to 66.9 percent for EU
countries. Similarly, SMEs in Iceland have contributed 70.1 percent of the total value added by
business sector, while their counterparts in EU countries contributed 58.1 percent (European
Commission, 2014).
2. In October 2008, the three largest Icelandic banks crumbled and were instantaneously nationalized
after defaulting on their short-term debt obligations. This caused authorities to impose currency
restrictions and capital controls, which largely restricted banks’ lending ability (Baldursson and
Portes, 2013).
3. For the most parts of the past two decades, the three largest Icelandic banks have
dominated over 70 percent of corporate lending, while over 90 percent of the bond
market consists of securities issued by government. The following is the distribution of
corporate lending by the three main banks: Arion banki (Kaupthing) 26 percent, Landsbankinn
26 percent and Íslandsbanki (Glitnir) 21 percent (Financial Supervisory Authority of
Iceland, 2012). Moreover, the Icelandic stock exchange has been relatively small and illiquid
between 2009 and 2012 with less than ten listed firms and market capitalization around
20 percent of annual gross domestic product (GDP), a significant decline from market
capitalization amounted to 200 percent of annual GDP in the year 2006 (Nasdaq OMX Nordic,
2015; World Bank, 2014).
4. By the end of the year 2013, the Icelandic stock exchange contained only nine listed firms
(Nasdaq OMX, 2014).
5. The industrial distribution consists of the following five main sectors: leisure, durable goods,
natural resources, media and transport, and manufacturing and construction.
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Appendix Impact of
financial and
economic crisis
Duration of financial distress Percentage of firms

Without any financial distress at all 15

Financially distressed for one year 15 315
Financially distressed for two years 29
Financially distressed for three years 24
Financially distressed for four years 17 Table AI.
Notes: The table shows the summary statistics for the overall percentage of financially distressed firms Percentage of
based on annual debt coverage ratio (DCR) defined as net income over interest expenses. The financial financially distressed
distress represents firms with DCR of less than 1. The sample contains 330 of the largest 400 Icelandic private firms based on debt
firms from 2006 to 2012 coverage ratio

Corresponding author
Twahir Khalfan can be contacted at: kibabu999@gmail.com

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