New Evidence on Measuring Financial Constraints: Moving Beyond the KZ Index

Review of Financial Studies (Impact Factor: 4.75). 04/2010; 23(5):1909-1940. DOI: 10.1093/rfs/hhq009
Source: RePEc


We collect detailed qualitative information from financial filings to categorize financial constraints for a random sample
of firms from 1995 to 2004. Using this categorization, we estimate ordered logit models predicting constraints as a function
of different quantitative factors. Our findings cast serious doubt on the validity of the KZ index as a measure of financial
constraints, while offering mixed evidence on the validity of other common measures of constraints. We find that firm size
and age are particularly useful predictors of financial constraint levels, and we propose a measure of financial constraints
that is based solely on these firm characteristics.

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    • "These control variables improve comparability with prior studies and reduce the possibility that investment efficiency is a function of correlated omitted variables. As a proxy for firm size (SIZE), we use the natural logarithm of dollar value of total book value of assets; Cash flow sensitivity (S_CASH) is measured as the standard deviation of cash and short term investments from year t-3 to year 3; age (LN_AGE) is measured as the natural logarithm value of the number of years between fiscal year and Compustat listing year; tangibility (TANG) is calculated as the ratio of tangible fixed assets to total assets; return on assets volatility (S_ROA) is the standard deviation of return on assets from year t−4 to year t; to measure growth opportunities we include Tobin's Q (TOB_Q) as the market value of equity minus the book value of equity plus the book value of assets, all scaled by the book value of assets; to control for the financial solvency of the firm, we employ an index of financial constraints (F_CONS) developed byHadlock and Pierce (2010)as:−0.0737*SIZE+ 0.043*SIZE 2 −0.040*AGE; we include a dummy variable (LOSS) that takes the value of one if net income before extraordinary items is negative, and zero otherwise; we also include the ratio of cash flow to total assets (CASH_AT); and a firm's leverage (LEV) as the ratio of the book value of total liabilities and debt scaled by the book value of total assets. "
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    • "Our difference is to tackle this with an instrument that has some economic rationale. Our work shares with Hadlock and Pierce (2010) "
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