Event Details

Accounting and Finance, Finance Seminar, presented by Sudipto Dasgupta. Paper title: Balance Sheet Financial Flexibility.

Dasgupta, Sudipto – CUHK Business School

Abstract

Firms’ investment behavior is intermittent, and a significant fraction of capital formation

occurs during “investment spikes”. We define financial flexibility as the capacity

to accommodate investment spikes, as potentially determined by (i) external financing

frictions, and (ii) the state of firms’ balance sheets. We term the contribution of

balance sheet variables to overall financial flexibility balance sheet financial flexibility.

We construct a balance sheet financial flexibility index (FF Index) by examining which

balance sheet financial variables differentiate firms that generate investment spikes and

those that do not during industry-level investment spike waves, which capture periods

when an entire industry experiences positive shocks to investment opportunities. We

consider five popular measures of financial constraints (FC), including recent “textbased”

measures, and find that these measures have very little in-sample explanatory

power compared with our selected balance sheet variables. The FF Index predicts the

incidence of investment spikes in out-of-sample tests and outperforms all FC Indices.

We validate our empirical approach using data simulated in a model adapted from

Gao, Whited, and Zhang (2021). As an application, we show that the FF Index predicts

the capacity of firms to sustain investment during economic downturns, and again

outperforms the FC Indices.