Many companies across the world are looking for ways to improve firm investment strategies. As the economy continues to falter, many companies are cutting back on their spending as they try to balance their books. However, it is also seen that the influence of financial leverage on firm investment isn’t as great for low information asymmetric businesses. However, no such significant relationship exists between financial leverage and firm investment for medium-sized to large-scale companies. This paper discusses why firms of different sizes have varying needs for financial leverage.
All firms seek to improve productivity by using available human and physical resources. It is in this context that financial leverage becomes important. A company can leverage its assets by increasing the supply of assets (firms may own physical assets like factories or land, but also have access to finance if needed through banks) and using its existing productive capacity to increase firm production while reducing costs. In terms of fiscal policy, higher government debt can create opportunities for fiscal stimulus by replacing current loans with more secure external financing.
There are two main reasons why firms make large investments in human capital: to capture new knowledge and to increase productivity. Knowledge capture describes a set of activities aimed at maximizing the firm’s competitive advantage through the use of research and development (R&D). This involves creating new or innovative products, processes, or processes that are relevant to the firm’s products and/or services, or taking advantage of advances in specific technological areas. Productivity enhancement refers to the ability of a firm to realize and utilize its human capital. This goal can be achieved through training, specialization, and implementation of techniques that improve employee output or quality.
The third major reason why firms make such large investment in external finance is because they are less competitive in domestic markets. Less competitive firms can take advantage of their domestic resources (such as human capital) to compete with international competitors, but they cannot do so if they have few domestic customers or a small market share. For these firms, internal expansion is the only way to achieve competitive advantages. External finance therefore enables competitive firms to attract and retain the best employees, which allow them to penetrate and capture markets that would be too challenging for them to enter without outside financing. By contrast, domestic financial instruments such as bonds and loans provide a firm with temporary external financing and therefore are more problematic for a firm that has a history of poor investment habits.
To examine the relationships between firms’ investment decisions, it is important to understand the various sources of financing that firms normally use. One common source of funding is short-term borrowings (e.g., bank loans and line of credit). Another common source of financing is long-term borrowings (e.g., commercial loans). A relatively new source of financing is foreign investment (e.g., foreign direct investment). A final common source of financing is market financing – commonly used by small firms to finance growth activities. In this case, financing is used to acquire specific technologies or operational systems that a domestic firm would otherwise be unable to acquire on its own.
The relationships between firms’ investment decisions and internal cash flow appear most clearly in the case of small and medium firms. Small and medium firms typically face a number of competitive pressures to expand their current operations, respond to customer demands, or increase the firm’s profitability. In all these cases, internal funds provide a source of temporary funding that significantly increases a firm’s potential for expansion, as well as its ability to respond quickly to changing circumstances. However, even when firms have adequate internal funds to fund their growth, external financing can still play a role in determining the scale and type of expansion undertaken by a firm.