Do Measures of Financial Constraints Measure Financial Constraints?
Executive Summary — A core question in corporate finance is how financial constraints affect firm behavior. To answer this question we need a way to identify constrained firms with reasonable accuracy. Since the financial constraints that a firm faces are not directly observable, scholars have tended to rely on indirect proxies-such as having a credit rating or paying dividends-or on one of three popular indices based on linear combinations of observable firm characteristics such as size, age, or leverage (the Kaplan-Zingales, Whited-Wu, and Hadlock-Pierce indices). In this paper the authors ask: How well do these measures of financial constraints identify firms that are plausibly financially constrained? The short answer is: not well at all. The authors develop three different tests that show that public firms classified as constrained have no trouble raising debt when their demand for debt increases, are unaffected by changes in the supply of bank loans, and engage in paying out the proceeds of equity issues to their shareholders ("equity recycling"). Results imply that popular measures of financial constraints tend to identify as constrained subsets of firms that differ from the general firm population of public firms on a number of dimensions, but not in their ability to raise external funding. Importantly, the tests developed by the authors can be used to systematically test the extent to which any measure of financial constraints does capture constraints. Key concepts include:
- Popular measures of financial constraints do not do a good job of identifying firms that are plausibly financially constrained.
- None of the five measures the authors evaluate using three different tests is able to identify firms that behave as if they are in fact constrained.
- Previous studies' findings that have been attributed to financial constraints are more likely to be caused by some other difference in firm characteristics, such as size, age, growth rates, or preferred funding source.
- There are problems with the popular practice of using coefficients from the Kaplan-Zingales, Whited-Wu, and Hadlock-Pierce indices to extrapolate to other samples and time periods in an effort to identify potentially constrained firms.
- The authors' tests can be used to systematically test the extent to which any measure of financial constraints does capture constraints.
Financial constraints are not directly observable, so empirical research relies on indirect measures. We evaluate how well five popular measures (paying dividends, having a credit rating, and the Kaplan-Zingales, Whited-Wu, and Hadlock-Pierce indices) identify firms that are financially constrained, using three novel tests: an exogenous increase in a firm's demand for credit, exogenous variation in the supply of bank loans, and the tendency for firms to pay out the proceeds of equity issues to their shareholders ("equity recycling"). We find that none of the five measures identifies firms that behave as if they were constrained: public firms classified as constrained have no trouble raising debt when their demand for debt increases, are unaffected by changes in the supply of bank loans, and engage in equity recycling. The point estimates are little different for supposedly constrained and unconstrained firms, even though we find important differences in their characteristics and sources of financing. On the other hand, privately held firms (particularly small ones) and public firms with below investment-grade ratings appear to be financially constrained.