Financial Leverage and Firm Investment

External financing accounts for more than 40 percent of firm investment. The majority of these sources are commercial banks and development banks, while less than two percent are informal sources. Other sources include suppliers, equity investments, and leasing. The remaining five percent are not publicly traded and are private, resulting in significant variation in the amount of funds invested in firms. Using the data from this survey, we identify several factors that influence firm investment. Let’s take a closer look at these factors.

Firm Investment

Financial Leverage – The degree to which firms use financial leverage is associated with their investment decisions. Specifically, firms with high financial leverage are more likely to invest in the most promising ventures. Furthermore, companies with high information asymmetry are likely to have the highest level of internal cash flow. As a result, the relationship between financial and firm investment is most pronounced in firms with lower growth rates. However, this relationship is weaker for high-growth firms.

Underlying Factors – The relationship between firm investment and financial leverage is a key point in understanding why firms invest and how they use it. Financial leverage is positively associated with firm investment. This relationship is strongest for firms with high information asymmetry, low growth, and high financial leverage. While this relationship is not as strong for low-growth firms, it does exist for those with high information asymmetry. It is worth noting that these factors may be interrelated, but they do not necessarily imply a causal relationship between finance and firm investment.

In addition, financial leverage and firm investment are directly related. In particular, financial leverage is negatively associated with firm investment and sensitivity to internal cash flow for high-credit-worthiness firms. Similarly, less-creditworthy firms are not affected by internal cash flow as much as higher-credit-worthiness firms are. Further, the relationship between financial leverage and firm investment is strong for low-growth but not for high-growth firms. This suggests that financial leverage and firm investment are interrelated, but there are many variables that influence the relationship.

The level of financial leverage affects firm investment. In high-information asymmetric firms, financial leverage has the largest effect on firm investment. In general, the more creditworthy firms are, the less likely they are to invest. In contrast, high-information asymmetric firms are more sensitive to internal cash flow than lower-creditworthiness firms. Further, the greater the leverage, the higher the risk a company’s risk is. Aside from a negative relationship with financial leverage, the other factors that influence a firm’s investment decisions are:

The level of financial leverage affects firm investment decisions. In high-information asymmetric firms, financial leverage affects their capitalization and the rate of internal cash flow. In high-information asymmetric firms and high-growth firms, the relationship between firm investment and leverage is positive. For example, a firm with high debt is more likely to invest in a lower-growth company. In high-growth countries, higher levels of financial leverage affect a firm’s ability to obtain debt.