Firm Growth and Liquidity Constraints:
A Dynamic Analysis
Using a large unbalanced panel data set of
Portuguese manufacturing ﬁrms surviving over the period from
1990 to 2001, the purpose of this paper is to examine whether
liquidity constraints faced by business ﬁrms aﬀect ﬁrm growth.
We use a GMM-system to estimate a dynamic panel data model
of ﬁrm growth that incorporates cash ﬂow as a measure of
liquidity constraints and persistence of growth. The model is
estimated for all size classes, including micro ﬁrms. Our ﬁndings
reveal that smaller and younger ﬁrms have higher growth-cash
ﬂow sensitivities than larger and more mature ﬁrms. This is
consistent with the suggestion that ﬁnancial constraints on ﬁrm
growth may be relatively more severe for small and young
ﬁrms. Nevertheless, the same ﬁnding can be interpreted in a
diﬀerent way if we consider the more recent literature which
interpret the higher investment/cash ﬂow sensitivity of younger
and smaller ﬁrm in absence of ﬁnancial market imperfection as
the outcome of these ﬁrms reaction to the fact that realisation
of their cash ﬂows reveals them the direction to go in presence
of uncertainty of their growth prospect. Besides, ﬁrms that were
small and young at the beginning of the sample period exhibited
more persistent growth than those that were large and old.
Finally, these results have signiﬁcant policy implications.
KEY WORDS: ﬁrm growth, ﬁrm size, GMM estimator,
liquidity constraints, panel data.
JEL CLASSIFICATION: C23, G32, L11.
The availability and cost of ﬁnance is one of the
factors which aﬀect the ability of a business to
grow (Binks and Ennew, 1996a: 17). The growth
of ﬁrms, especially small and young ﬁrms, is
constrained by the quantity of internally gener-
ated ﬁnance available. Butters and Lintner (1945:
3) provide some of the earliest research to support
this theory. They conclude that ‘‘(m)any small
companies – even companies with promising
growth opportunities – ﬁnd it extremely diﬃcult
or impossible to raise outside capital on reason-
ably favourable terms’’ and that most small ﬁrms
ﬁnance their growth almost exclusively through
retained earnings. Recent empirical evidence
indicates that, due to asymmetric information
and diﬀerent collateral value between ﬁrms of
diﬀerent size, the wedge between the cost of
internal and external ﬁnance may be large for
In relation to this, the ﬁnancing
constraints theory also complements recent re-
search that emphasizes how access to ﬁnance af-
fects ﬁrm formation, survival and growth.
In eﬀect this research combines two strands of
economics literature, that of the investment lit-
erature and that of the ﬁrm growth literature.
With respect to investment literature, it is to en-
hance the original work of Fazzari et al. (1988)
that study the relationship between ﬁnancing
constraints and the investment/cash ﬂow sensi-
tivity. Based on Fazzari et al. (1988), Carpenter
and Petersen (2002) focus on the relationship
between ﬁnancing constraints and ﬁrm growth.
Subsequently, built on Carpenter and Petersen
(2002) and take into account the critiques to
Fazzari et al. (1988) the present study employs
the ﬁnancing constraint literature to explain the
dynamics of the growth of the ﬁrms. We apply
dynamic panel data techniques to an extended
ﬁrm growth speciﬁcation that also includes per-
sistence of chance and liquidity constraints
proxied by cash ﬂow. This study makes signiﬁ-
cant contributions to the literature on the
dynamics of ﬁrm growth. First, we investigate the
eﬀects of internal ﬁnance on ﬁrm growth in the
Final version accepted on February 3, 2006
Escola Superior de Tecnologia e Gesta
Morro do Lena-Alto Vieiro Apartado 4163,
2411-901 Leiria, Portugal.
Faculdade de Economia da Universidade de Coimbra,
Av. Dias da Silva 165, 3004-512, Coimbra, Portugal.
Small Business Economics (2006) 27: 139–156 Ó Springer 2006