Do firms generate financial flexibility by retiring debt? Using Indian data, we document that firms channel approximately 39% of current cash flow to repay debt. This higher debt-cash flow sensitivity facilitates the firms to maintain investments in future by borrowing. In the short run, firms reduce their dependence on costly external finance, increase investments and save cash for the future. In the long run, firms step up their investments by borrowing more and drawing on their cash hoards. Unlike in developed markets, we find that firms respond symmetrically to positive and negative cash flow shocks by making changes in their capital structure. The sensitivity of borrowings to internal cash flows is a prima-facie indication of financial frictions faced by Indian firms. By decreasing the debt, firms can reduce the debt overhang issues and associated financial distress costs. Our subsequent analyses indicate that firms with high leverage (financially less-flexible firms) retire more debt than firms that are less levered (financially more-flexible firms), which saves more cash. We also document how group-affiliated firms allocate cash flows differently from stand-alone firms. Overall, we find that financing-cash flow sensitivities are higher than investment-cash flow sensitivities, which is intuitive because of the difference in adjustment costs involved. Our results also underscore the importance of borrowed funds as an important financing source in emerging markets where (a) bank-based private debt is cheaper and (b) provides a tax shield.
