Prof. Sudipto Dasgupta is a Professor of Finance at The Chinese University of Hong Kong (CUHK) Business School . Detailed profile can be found at here.
The Chinese University of Hong Kong Business School
July 11, 2024
Inferring Financial Flexibility: Do Actions Speak Louder than Words?
Firms invest intermittently, and a significant part of capital formation occurs during “investment spikes”. Industry-level “spike waves”, during which growth opportunities in an entire industry surge and a large fraction of firms in the industry generate investment spikes, also occur quite regularly. We define financial flexibility as the capacity to accommodate large shortfalls between a firm’s investment needs and cash flows, as is the case when it has an investment spike. We develop an index for financial flexibility (FF) based on which firm-specific variables differentiate firms that generate investment spikes and those that do not during industry spike waves. In out-of-sample tests, our FF Index outperforms five popular financial constrained (FC) indices in predicting investment
spikes, as well as investment growth, and future sales growth. We use ChatGPT to “read” the “Liquidity and capital Resources” section of a large sample of firms’ 10-Ks and generate alternative FF and FC measures; however, FF also outperforms these measures. The superior performance of our FF measure suggests that firms’ actions are
more revealing of their financial status and its determinants than what is disclosed in annual reports. 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 ∗All comments are welcome. The paper was previously circulated under the title “Balance Sheet Financial Flexibility”. We thank seminar participants at the Australian National University, Chinese University of Hong Kong, Deakin University, Queensland University of Technology, Singapore Management University, PBCSF Tsinghua University, The Hong Kong University of Science and Technology, Toulouse School of Business, and participants at the China International Conference of Finance (CICF) 2023, American Finance Association (AFA) 2024 Annual Meeting, and the 7th Vietnam International Conference in Finance, Kentaro Asai, Ran Duchin (discussant), David Matsa, Rik Sen, Manpreet Singh (discussant), Oren Sussman, and Sheridan Titman for valuable comments. We are especially grateful to Bill McDonald for sharing with us sentiment counts for all 10-K filings through 2021.
