ESG footprint and investment-cash flow sensitivity: the role group affiliation

Modigliani and Miller's (1958) propositions in the corporate finance literature delineate investment decisions as independent of financing choices (Sinha and Sawaliya, 2021). In their framework of a perfect capital market, both internal and external finance are portrayed as exact substitutes due to the absence of market friction. However, such a perfect capital market does not exist in the real world as there is a lot of friction in the market (Dash and Sethi, 2024; Kuo and Hung, 2011; Myers and Majluf, 1984). This friction can result from information asymmetry, as proposed by the pecking order theory (Myers and Majluf, 1984), agency problems outlined in agency theory (Jensen, 1986), taxes and various transaction costs emphasized in the static trade-off theory (Myers, 1977). The difference in cost of internal and external funds motivates a manager to choose wisely between these two alternatives, and imperfectness in the capital market makes the external sources of funds even more costlier than internal sources (Gupta, 2022). Hence, a firm prefers internal funds (cash flow) over external sources in the investment decision when facing financial constraints (Dash et al., 2023). Consequently, realizing the significance of operating cash flow in the investment decision, substantial attention has been paid by researchers across the globe to investigate the dependency of investment on firm’s cash flow, which is known as investment-cash flow sensitivity (ICFS) after pioneering work of Fazzari et al. (1988). Fazzari et al. (1988) demonstrated that firms experiencing financing constraints, indicated by lower dividend payments, rely heavily on internal cash flows. They concluded that disparities in the costs of capital between internal and external sources, reflecting capital market frictions, could lead certain firms to discard projects with positive net present value. Several studies using various indicators of financial constraints, such as dividend payout, firm size, age and debt ratings, corroborate the findings of Fazzari et al. (1988).

In contrast, Kaplan and Zingales (1997), Kadapakkam et al. (1998) and Cleary (1999, 2006) counter this perspective, indicating that the investment decisions of the most financially constrained firms display a minor sensitivity to internally generated cash flows. This disparity has ignited an ongoing argument on ICFS. However, despite the growing interest on ICFS in the corporate finance literature, there is a scarcity of literature emphasizing the influence of the environmental, social and governance (ESG) footprint on ICFS.

In the present era of climate change and the fluctuating business environment, ESG plays a prominent role in a firm’s success (Dash and Sethi, 2024). Adopting ESG practices is mainly driven by stakeholders’ pressure and the long-term benefits to the firm. ESG plays a crucial role in mitigating information asymmetry between external investors and firms, consequently reducing the cost of capital (Lian and Weng, 2024). Adequate and transparent dissemination of ESG data creates a better ESG footprint and enables stakeholders to understand a firm’s operational practices, risk management protocols and long-term sustainability strategies (Dash and Sethi, 2024). This enhanced transparency fosters trust and confidence among investors, thereby encouraging greater investment and potentially leading to decreased financing costs for the firm. Furthermore, ESG footprint attracts a wider investor base, particularly those engaged in sustainable and socially responsible investing, thereby expanding financing opportunities for firms, especially those facing financial constraints.

Consequently, by alleviating the underinvestment problem, a better ESG footprint enhances investment efficiency and contributes to the overall financial health of firms (Lian and Weng, 2024). At the same time, adopting ESG practices in a firm also demands a certain amount of challenges, such as regulatory and investor compliance burdens, chances of damaging the firm’s reputation if the firm fails to meet ESG standards, which in turn hamper investors’ confidence and increase the cost of capital. Adopting ESG also reduces financial flexibility if the firm channeled most of its funds toward ESG; as a result, investment in other long-term projects may be missed (Hai et al., 2022). The Securities and Exchange Board of India (SEBI) recently introduced mandatory ESG disclosure norms [¹] to enhance corporate accountability and sustainability in India. Effective from FY 2023–2024, the regulations require the top 1,000 listed companies to report detailed ESG metrics under the Business Responsibility and Sustainability Reporting framework. Companies must disclose their environmental impact, social responsibilities and governance practices, aligning with global sustainability standards. These measures promote transparent and responsible business practices and attract ESG-conscious investors to the Indian market. Noncompliance may result in penalties, further tightening corporate governance norms. Furthermore, Hai et al. (2022) advocate that business group affiliates tend to disclose ESG information more than standalone firms. Due to their substantial social impression, business groups may feel a stronger incentive to engage in social and environmental disclosure, driven by corporate branding, public pressure, group image and the cost of violations (Huang et al., 2021). Thus, firms are at a crossroads in balancing social and environmental responsibilities with economic growth, and empirically testing the impact of ESG on ICFS is necessary. Through this paper, we have made a novel attempt to address some pertinent questions, such as whether Indian manufacturing firms depend on their cash flow for investment? Does ESG have any impact on ICFS? Does group affiliation moderate the ESG-ICFS nexus?

Furthermore, this study also tackles the abovementioned issue for the manufacturing sector of emerging countries like India. India stands out among developed and other emerging economies, demanding particular attention in ICFS research. The country’s politically active nature results in investment fluctuations due to governmental changes (Gupta, 2022). In addition, numerous factors highlight India as an investment-rich nation where ICFS is a critical concern. Firstly, according to the Global Manufacturing Risk Index 2021 [²] (GMR Index 2021), India has become the world’s second-largest manufacturer, surpassing the US as the second-most preferred global manufacturing destination, driven by cost competitiveness. Moreover, the Indian manufacturing sector aims to achieve a US$1tn valuation by 2025 (Gupta, 2022). Second, implementing the Goods and Services Tax attracts retail and institutional investors. Third, the Government of India (GOI) has introduced several initiatives like Make in India and hosting the G20 Summit, which enhance the global momentum of the Indian manufacturing sector. Fourth, the GOI plans to create a hundred million jobs shortly, potentially liberalizing investment policies and encouraging increased firm investments (Gupta, 2022). Factors such as a growing middle class, a youthful population and strong domestic demand also position India as a promising investment destination. Fifth, as a planned economy, India’s comprehensive growth across various sectors makes it an attractive and secure option for foreign investors.

Moreover, the IBEF [³] (India Brand Equity Foundation) report indicates that the GOI has launched numerous programs to boost the Indian economy as a prime investment hub, including the New Industrial Policy and permitting 100% foreign direct investment in outsourced manufacturing through the automated route. India also benefits from competitive advantages such as demographic dividends, an exceptional and relatively low-cost workforce and robust engineering expertise supported by scientific and technical institutions. In addition, reforms in the Indian capital market by SEBI have bolstered investor confidence. India aspires to be the third largest economy in the world by 2030, implementing various reform measures to achieve this goal. Thus, the relevance of ICFS in emerging economies like India is evident.

In the above backdrop, this paper offers several unique contributions to the growing literature on ICFS and its intersection with ESG factors, specifically within the context of emerging economies like India. Our research is positioned to address critical gaps in the literature by examining how ICFS varies within the Indian corporate landscape and how ESG practices and business group affiliation influence this dynamic. First, we contribute to the limited understanding of ICFS in the Indian context, where market conditions, financial systems and regulatory environments differ significantly from developed economies. The Indian economy, characterized by a diverse corporate sector ranging from multinational corporations to family-owned business groups, presents unique financial challenges. In this environment, access to external finance may be constrained, and internal funds play a pivotal role in determining corporate investment behavior. While ICFS has been extensively studied in developed economies, little research has focused on emerging markets like India. Our study addresses this gap by providing empirical insights into the determinants of ICFS in India, thereby contributing to a deeper understanding of how internal capital markets operate in an emerging economy setting. We examine how firms’ reliance on internal funds influences their investment decisions, especially in a country where access to capital may be limited for certain firms, depending on their size, ownership structure or market power.

Second, we extend the ICFS literature by integrating ESG factors, which have become increasingly relevant as businesses worldwide respond to growing pressures for sustainability and responsible corporate governance. The inclusion of ESG in financial decision-making is a relatively new concept in the literature on ICFS, particularly in emerging markets. Our paper contributes novel insights by investigating how a firm’s ESG performance interacts with its investment–cash flow relationship. We hypothesize that firms with stronger ESG practices might face lower financial constraints, leading to reduced ICFS, as ESG-oriented companies tend to attract more capital from responsible investors and have better access to credit. Conversely, firms with poor ESG performance may face higher financing costs, thus, experiencing a stronger reliance on internal funds for investment. This study is one of the first to explore these interactions in the Indian market, making it a crucial addition to understanding how sustainability initiatives influence corporate financial behavior.

Finally, this paper uniquely investigates the role of business group affiliation in moderating the relationship between ESG performance and ICFS. Business groups, which dominate much of the Indian corporate landscape, have complex internal capital markets, which can potentially alleviate financial constraints by facilitating resource allocation within the group. However, their ESG practices may vary significantly due to differences in governance structures, family ownership and market orientation. We explore whether group-affiliated firms exhibit different ICFS patterns than standalone firms and how ESG factors play into these dynamics. Group affiliation could either amplify or diminish the effect of ESG on ICFS, depending on the internal capital efficiencies or inefficiencies within these groups. For instance, group-affiliated firms might face lower ICFS due to their ability to tap into intragroup financial resources, making the interaction between ESG performance and ICFS less pronounced. On the other hand, if ESG is viewed as a differentiating factor for market reputation, even group-affiliated firms may exhibit a strong ICFS–ESG relationship.

Hence, this paper breaks new ground by providing empirical evidence on three interconnected themes: ICFS in the Indian context, the role of ESG in shaping ICFS and the moderating effect of group affiliation on the ICFS–ESG relationship. These contributions provide a more nuanced understanding of how ICFS, sustainability practices and corporate ownership structures interact in an emerging economy like India, offering valuable insights for policymakers, investors and corporate managers. To the authors’ knowledge, this is the first paper which investigate the impact of ESG on ICFS in the context of group affiliation. The remaining sections include literature review, research methodology, empirical results, discussion and conclusion.

The crucial role of cash flow in guiding investment decisions, referred to as ICFS, was first highlighted by Fazzari et al. (1988). This discovery has sparked considerable interest among scholars seeking to understand the factors contributing to this phenomenon. Investment is regarded as a key indicator of a firm’s growth (Dash and Swain, 2020), yet the current volatile, uncertain, complex and ambiguous environment poses significant challenges to maintaining a steady investment strategy. Therefore, it is essential to examine each factor to make informed investment choices thoroughly. Some firms have positive cash flow sensitivity, while others have negative ICFS (Carpenter and Guariglia, 2008). According to the original interpretation of cash flow sensitivity by Fazzari et al. (1988), firms with positive cash flow sensitivity are more likely to encounter high external capital costs than cash-flow-insensitive firms. These companies are typically smaller and younger, distribute lower dividends and are remotely expected to possess a bond rating, especially an investment-grade rating. They also exhibit lower asset tangibility (Hovakimian, 2009). They maintain considerably higher financial slack to preempt potential liquidity issues. At the same time, some firms also show negative sensitivity toward cash flow while making their investment agenda. To a large extent, the adverse correlation appears to stem from the divergence in trajectories of cash flows and capital expenditures among companies designated as negatively responsive to cash flow changes throughout their existence. Initially, these entities emerge into the public domain endowed with promising investment prospects but meager earnings. Their capacity to secure substantial debt and equity suggests that market sentiment regards their investment ventures as highly profitable despite their minimal present cash flows.

Moreover, their initial cash flow deficiencies render synchronizing investments with periods of ample cash impractical. Initially, the dearth of cash flow necessitates a prolonged period for it to become a significant financing source. In addition, abstaining from current investments may impede the realization of future cash flow increments. Consequently, these companies tend to allocate most of their investments during periods of minimal cash flow, predominantly relying on external funding. As per the corporate life cycle hypothesis, their previous investments yield higher cash flows as they mature, coinciding with a deceleration in investment rates due to diminishing lucrative opportunities. These synchronous shifts in cash flows and investment rates give rise to an adverse empirical correlation between investment and cash flow. So, far as Indian manufacturing firms are concerned, they are financial constraints due to high market imperfection and lack of robust financial system (Dash et al., 2023; Dash and Sethi, 2024; Dash and Swain, 2020). Hence, the following hypothesis may be developed for ICFS in Indian context:

Next, this paper debates that ESG lessens the ICFS in manufacturing concerns. Waddock and Graves (1997) assert that environmental and social initiatives of a firm strengthen linkages with important stakeholder groups and lower a firm’s perceived risk (Cheng et al., 2014). Their argument is based on “good management theory.” According to Turban and Greening (1997), environmental and social initiatives aid businesses in retaining qualified personnel and attracting eligible consumers, which can produce valuable intangible assets (e.g. improved customer and employee loyalty, enhanced capacity to recruit and retain better quality staff). These intangible assets improve a company’s competitive position, improving financial performance (Attig et al., 2014; Legnick-Hall, 1996). Furthermore, El Ghoul et al. (2011) suggest that socially responsible activity or ESG performance expands a company’s investor pool and lowers perceived risk by reducing the likelihood of future legal action. Therefore, these pieces of evidence give a consensus that ESG boosts corporate value and competitiveness and aids in risk management. In such context, this paper proposes that ESG can abate market imperfection, hence, influencing the “wedge” between internal and external funds through two major channels. First, as expenditure on environmental, social and governance systems is long-term in nature (Johnson and Greening, 1999), we anticipate that such a long-term approach will build strong connections with stakeholders, reduce information asymmetry, ensure effective use of firm resources and reduce uncertainty for firm.

Second, we anticipate that ESG will reduce the “wedge” between the costs of internal and external funds by lowering the borrowing cost (Attig et al., 2014) and reducing uncertainty about potential future claims (Waddock and Graves, 1997), as better ESG performance ensures good governance system complied by robust grievances redress mechanism, transparent disclosure, environmental consciousness and socially responsible behaviour of the firm. Attig et al. (2014) suggest that ESG not only builds goodwill for the firm but also reduces agency costs, by which a firm can avoid unnecessary investment and reduce borrowing costs that arise due to failures of investment in the past. Furthermore, bigger Wall Street coverage of companies with high levels of corporate social responsibility attracts more media attention and investor interest and drives up demand for information disclosure (Hong and Kacperczyk, 2009). Particularly, environmentally and socially concerned investors may overlook information about poor ESG businesses and focus more on data about high ESG enterprises (Attig et al., 2014). As a result, high ESG businesses are anticipated to provide more information (Attig et al., 2014; Dhaliwal et al., 2011). Study by Kim et al. (2012) shows that socially conscious companies are more likely to encourage managers to provide excellent quality financial reports and minimize earnings management. This result is consistent with the role of ESG in raising the standard of corporate information. Similar to this, Attig et al. (2011) demonstrate that credit rating agencies frequently give high ratings to top socially responsible firms. Briefly, the enhanced information quality brought by ESG would probably mitigate the risk arising due to asymmetric information, improve monitoring quality and help the firm in accessing external fund in a cheaper cost, making ICFS weaker. However, Mahfoozi et al. (2017) advocate that good social performance also encourages firm to use its cash flow as most of the CSR spending firms have good financial positions; hence, instead of going outside, they choose internal funds, making ICFS higher.

In this light, the paper proposes the following hypothesis:

The growing emphasis on green and sustainable practices has compelled companies to incur additional costs or sacrifice revenue to enhance their environmental performance (Fatemi et al., 2018; Hai et al., 2022; Kim and Lyon, 2014). However, excessive commitment to environmental and social responsibilities can divert resources from other projects, potentially diminishing firm value (Hai et al., 2022; Sen et al., 2006). This concern leads some firms, particularly standalone ones with limited resources, to be hesitant in disclosing ESG-related information. In contrast, group-affiliated companies are more likely to release such information (Hai et al., 2022). Business groups, formed through formal and informal ties, operate as unified entities that can pool resources internally and access external market resources (Huang et al., 2021; Sethi, et al., 2021). This internal capital market within business groups helps affiliates overcome financial constraints by providing internal funding, enabling them to invest more in social responsibility without resource allocation issues (Gupta and Mahakud, 2022; Hai et al., 2022; Huang et al., 2021).

Business groups are especially significant in emerging markets, where they help mitigate external capital market imperfections (Almeida and Wolfenzon, 2006; Khanna and Rivkin, 2001). The internal capital market within these groups offers advantages like economies of scope and scale, improved resource allocation and risk-sharing, enhancing their market value (Hai et al., 2022; Sethi, et al., 2021). In addition, business groups have a separate management and control system at the group level. However, research has revealed that these internal capital markets can be inefficient. According to agency theory, agents in these relationships might pursue low-profit, high-risk projects for personal gain, leading to issues like tunneling behavior and conflicts between large and small shareholders (Hai et al., 2022). The widespread use of pyramid structures in business groups exacerbates these agency problems by increasing the separation between management control and cash flow rights (Hai et al., 2022; Huang et al., 2021). This asymmetry can lead to financial malpractices, such as hollowing out companies, affecting dividend policies and increasing financial costs, ultimately reducing the market value of holding companies.

In India, most firms are affiliated with business groups (Gupta and Mahakud, 2022). It is crucial to study the impact of ESG on internal capital flows for both group-affiliated and standalone firms. Research indicates that business group firms face fewer financial constraints compared to standalone firms (Dash et al., 2023; Dash and Swain, 2020), which are highly constrained. This is because group firms benefit from internal capital markets and can easily raise funds due to their reputation and political connections (Hai et al., 2022; Huang et al., 2021). Cash-rich firms, however, may over-invest due to managers’ empire-building motivations (Biddle et al., 2009). Stronger external supervision can mitigate this by curbing agency behavior and enhancing investment efficiency (Hai et al., 2022). Active participation in ESG activities can improve stakeholder relations and oversight, reducing over-investment (Cheng et al., 2014). Hence, ESG disclosures by group affiliates might serve as an external monitoring mechanism, mitigating agency problems and reducing over-investment within the business group:

Further for a comprehensive understanding on ICFS, ESG and group affiliation relationships the key studies along with expected relationships are presented the Table 1.

The data are collected from the “prowess” database of “Centre for Monitoring Indian Economy” (CMIE), Bloomberg database, for a period of 11 years from 2012 to 2022. This study is confined to listed manufacturing firms as such firms remain under obligation to pursue the regulatory prescriptions of the SEBI for recording and reporting of financial information. Firms involved in banking and financial services are excluded from the sample as they follow a different set of regulatory and financial reporting practices. Besides, firms having missing data are also not considered. So, a data set of 2,442 firm-year observations is assembled for 222 manufacturing firms. Furthermore, firms associated with any group are classified as group-affiliated firms, while those not associated with any group are treated as standalone firms. It was found in this study that 165 firms belong to business groups, whereas 57 firms are standalone. Data has also been winsorized at 99^th and 1^st percentile levels to remove outliers.

In line with the literature, investment has been taken as the dependent variable, and cash flow has been taken as the independent variable representing internal funds. Here, investment is the function of cash flow, which measures ICFS. Furthermore, investment is calculated as the change in the fixed asset from the previous year to the current year, and after that, investment is scaled by the previous year’s total asset. So, the beginning year of the sample period is not considered for estimation. This study uses ESG as moderating variable. Furthermore, Tobin’s Q, sales growth, firm size, firm age, liquidity, return on assets, gross domestic product growth and inflation rate have been used as control variables to address the influence of possible omitted variables. The description of variables is provided in Table 2.

The study uses a panel data set due to its distinct benefits like controlling of unobservable heterogeneity (Fazzari and Petersen, 1993; Hsiao, 2003; Moulton, 1986), gathering extensive observations, minimizing collinearity and providing technical efficiency (Koop and Steel, 2001). Furthermore, the study applies generalized methods of moments (GMM) regression to generate robust results. GMM corrects heterogeneity arising from the unobserved firm, time-invariant effects, measurement error, omitted variable bias, persistence and endogeneity problems (Caselli et al., 1996). Mainly, system GMM is appropriate for studies covering moderate periods where some variables are endogenous, and there is dynamic relationship between variables (Sheikh et al., 2018). Having 222 firms spanning over 11 years (i.e. n > T), the data set is fit to model through GMM. Investment $(IK)$ is considered as dynamic since it shows persistence and is influenced by past observations. Hence, the study tries to model the persistence through the GMM. Going by the supposition of Arellano and Bond (1991), Arellano and Bover (1995) and Blundell and Bond (1998), where present observation is influenced by its past observation, resulting in correlation of explanatory variables with error terms and estimation bias, all explanatory variables like Cash flow $(CFK)$⁠, ESG, Tobin’s Q, sales growth, firm size, firm age, liquidity and return on assets (ROA) have been considered as endogenous and their lags have been used as instrument to alleviate the possible endogeneity issue. The lag length of (0–5) has been used for all the variables. Dynamic panel data estimation has been conducted through two-step system GMM. This study has estimated six dynamic panel models where Model-I measures the ICFS, Model-II measures the moderating impact of ESG on ICFS, Model-III measures the ICFS for group affiliated firms and Model-IV measures the moderating impact of ESG on ICFS for group affiliated firms. Similarly, Model-V measures the ICFS for standalone firms, and Model-VI measures the moderating impact of ESG on ICFS for standalone firms. The baseline two models are as follows.

Models for ICFS:

The descriptions of the variables taken in the models are depicted in Table 1. In addition, a firm-specific effect Ѳ_i, time dummy γ_t and industry-specific effect φ_j (see Table A1 for industry classification) have been considered in the models. The subscript “i” represents firms, “t” represents years and “j” represents industry groups.

Models for moderating impact of ESG on ICFS:

The baseline second model’s variables are the same as the first baseline model above.

Furthermore, to ensure the robustness of our findings, we used alternative estimation techniques alongside the GMM regression. Specifically, we conducted a panel fixed effects analysis as a robustness check, following the suggestion of the Hausman test (see Table A2), which confirmed the appropriateness of the fixed effects model. This additional method allowed us to control for unobserved heterogeneity and time-invariant firm characteristics that could potentially bias the results. The consistency of our findings across both GMM and the fixed effects model strengthens the validity of our conclusions, providing confidence that our results are not sensitive to model specification and remain robust under different estimation techniques.

The study has the following conceptual model for better understanding.

Figure 1 demonstrates the conceptual model of the study. It illustrates the relationship between cash flow (Internal fund) and investment in Indian manufacturing firms, focusing on ICFS, as proposed in H1. The model also examines the impact of ESG practices on ICFS, as described in H2. Furthermore, the study explores how group affiliation moderates the ESG–ICFS relationship (H3). Control variables are included to enhance the accuracy of the analysis by reducing omitted variable bias and ensuring more robust results, as detailed in the variable table.

Table 3 illustrates the summary statistics of the variables. The mean $IK$ is 0.026, indicating that per year, Indian manufacturing firms spend around 3% of their total assets toward capital expenditure. The mean of $CFK$ is 0.11, which suggest that on an average Indian firms have cash flow around 11% of their total asset. The mean of ESG, Tobin’s Q, sales growth, liquidity, leverage, firm size, firm age, ROA, GDP growth and Inflation are 30.2, 3.10, 0.11, 0.37, 0.42, 10.6, 50.8, 6.55, 5.71 and 5.95, correspondingly. The values are consistent with the prior work of (Jarboui, 2017).

Before applying the multiple regression, it is necessary to check whether there is any strong association among independent variables or not. If it is so, it leads to a multicollinearity issue. Hence, through the correlation matrix and variance inflation factor, we tested the multicollinearity highlighted in Table 4. The correlation coefficient values between 0.001 and 0.734 (<0.80) indicate no collinearity, as recommended by (Gujarati, 2004). Furthermore, the highest variance inflation factors of 2.839 (<10) show the absence of a multicollinearity problem, as recommended by (Chatterjee and Hadi, 1977; O’Brien, 2007).

Table 5 highlighting the GMM regression result of Model-I, Model-II examines the ICFS, and checks the moderating impact of ESG on such relationships. The Hansen test, which establishes the overall validity of the instruments with the null hypothesis that “instruments as a group is exogenous,” has been used for the diagnostic test of GMM. As the p-value of the Hansen test is greater than 0.10, an inference can be made that the instruments used are robust. Furthermore, to prevent the over-identification issue, it is crucial that the number of instruments must be less than or equal to the number of groups. The model also meets this criterion, which indicates that the model is free from over-identification issues. Next, using the AR(1), AR(2) and AR(3) statistics, one may do further diagnostic tests to check for autocorrelation or serial correlation issues. The AR(1) depicts the first-order serial auto-correlation (i.e. “the differenced error term is serially correlated at AR(1), and AR(2) is considered a necessary test to detect autocorrelation at levels”). The null hypothesis of AR(2) statistics indicates “there exists no autocorrelation in the error term,” which is accepted in all the cases demonstrating the absence of autocorrelation in the model. AR(3) test has been performed to test the prevalence of auto-correlation at succeeding lag. The AR(3) statistics also demonstrate the absence of autocorrelation in the model.

The results of Model-I confirm H1, which states that “Indian manufacturing firms exhibit positive Investment-Cash Flow Sensitivity (ICFS).” This means that firms primarily rely on internal cash flow for their investment decisions. This finding is consistent with prior studies (Dash et al., 2023; Gupta, 2022; Gupta and Mahakud, 2020) which indicates that Indian manufacturing firms face financial constraints, where the cost of external capital is higher than internal capital due to factors such as information asymmetry and high borrowing costs. These constraints are consistent with the “pecking order theory” in corporate finance, which argues that firms prefer internal financing over external sources due to the lower cost and reduced risk.

Model-II supports H2, showing that ESG practices diminish ICFS. Firms with a strong ESG footprint are less dependent on internal funds for their investments. This finding suggests that ESG practices can improve a firm’s ability to access external financing by enhancing its reputation and reducing perceived risk, consistent with “signaling theory.” ESG-aligned firms send positive signals to investors and creditors, potentially reducing the cost of external financing and increasing access to capital markets.

Moreover, the study finds that lagged investment negatively impacts current investment, which reflects the constraints posed by previous-year investments. This is consistent with the “irreversibility theory” of investment, where firms with prior commitments may face difficulties or restrictions in making new investments due to limited liquidity and resource allocation. The results also reveal that investment opportunities (Tobin’s Q) and sales growth positively impact investment decisions. This aligns with “Q-theory” of investment, which posits that firms with higher growth prospects or market valuation (reflected in Tobin’s Q) are more likely to invest. Conversely, the negative impact of liquidity on investment indicates that firms with excess liquidity might not always channel these funds into productive investments, possibly due to “agency theory” concerns, where managers may not always act in shareholders’ best interests.

The study confirms that while Indian manufacturing firms are financially constrained, ESG practices help alleviate these constraints, improving access to external funding and reducing reliance on internal cash flow for investment. This outcome is critical in highlighting how integrating ESG can reshape firms’ financial strategies and capital structure choices. See Table 5.

Furthermore, as stated earlier, the majority of Indian firms are group affiliates (Gupta and Mahakud, 2022), and there are diverse opinions regarding ownership structure (group affiliates and standalone firms), ICFS and ESG performance (Almeida and Wolfenzon, 2006; Hai et al., 2022; Huang et al., 2021; Khanna and Rivkin, 2001; Sethi et al., 2021). One group of scholars advocates that group-affiliated firms have low ICFS due to low information asymmetry. In contrast, another group states that group firms have high ICFS due to the internal capital market, so they depend less on external funds. At the same time, group firms also spend more on ESG than standalone firms. Hence, this divergence of evidence motivates us to examine the association among group affiliates, ICFS and ESG in the Indian context. The results presented in Table 6 confirm H3, which proposes that the impact of ESG on ICFS is more pronounced in group-affiliated firms compared to standalone firms. Group firms demonstrate higher ICFS than standalone firms, indicating that group firms rely more heavily on internal cash flow for their investment decisions. This is likely because group firms benefit from the coinsurance effect, where financial resources are shared among sister firms within the group. This financial support boosts their confidence in using internal funds for investments, as the risks associated with cash flow constraints are lower. In contrast, standalone firms are more conservative with their internal cash flow due to precautionary and speculative motives, as they do not have access to external resources from affiliated firms, making them more cautious in exhausting their internal funds.

Regarding the ESG footprint, the findings show that ESG practices reduce ICFS in both group-affiliated and standalone firms, suggesting that firms with strong ESG commitments are generally less dependent on internal cash flow for investment. However, this reduction in ICFS is more significant in group firms. This may be because ESG practices further enhance group firms’ ability to access external capital markets by improving their reputation and reducing perceived risk, which adds to the coinsurance effect. For group firms, ESG acts as a dual buffer – first by mitigating reliance on internal cash flow through intragroup support and second by facilitating access to cheaper and more readily available external financing through better ESG ratings.

In the context of corporate finance theory, these results align with the pecking order theory, where firms prefer internal financing over external due to cost differences. With their coinsurance advantages, group firms can leverage internal cash flow more. However, signaling theory also plays a role, as ESG acts as a positive signal to the market, reducing the cost of external financing, especially for group firms. This is why the impact of ESG is stronger for group firms as they already have internal financial flexibility. They can now access external funds more efficiently, thus, relying less on internal cash flow for investment decisions. While benefiting from ESG, standalone firms do not enjoy the same internal risk-sharing and are, therefore, more dependent on internal cash flow despite ESG improvements.

The robustness of the findings is further supported by the results highlighted in Tables 7 and 8, which use a fixed-effects model following the recommendations from the Hausman test (see Table A2). This analytical approach addresses potential biases arising from unobserved heterogeneity, ensuring that the results are not driven by omitted variable bias or correlation between the regressors and the error term. The fixed-effects model allows for a more precise estimation of the relationships between the variables by controlling for individual firm characteristics that remain constant over time. The results from Tables 7 and 8 align closely with the main model, reinforcing the conclusions drawn regarding the ICFS and the impacts of ESG practices. Specifically, the fixed-effects analysis reaffirms that cash flow significantly influences investment decisions for both group-affiliated and standalone firms, supporting the initial findings of positive ICFS. In addition, the evidence shows that ESG practices consistently reduce ICFS across both firm types, with a pronounced effect in group firms, aligning with the outcomes discussed in the main model and confirming H3.

By using the fixed-effects model, the study enhances the reliability of its results, ensuring that the observed relationships are robust and not artifacts of the estimation method. This strengthens the argument that ESG practices provide significant benefits to firms, particularly those within groups, and that internal cash flow dynamics are a critical factor influencing investment strategies in the context of financial constraints and corporate governance. Overall, the consistency of the findings across different model specifications underscores the validity and relevance of the study’s contributions to understanding the relationship between cash flow, ESG and investment decisions in Indian manufacturing firms.

This study aims to examine the ICFS of Indian manufacturing firms. This study also investigates whether the ESG performance of a firm moderates the ICFS. Furthermore, the study explores the role of group affiliates in ESG and ICFS relationships. The result of the study aligns with our anticipation and shows that Indian manufacturing firms have high ICFS irrespective of group affiliated firms and standalone firms. Furthermore, a firm’s ESG performance affects ICFS and lessens the investment cash flow sensitivity. This impact of ESG on ICFS is more pronounced in group affiliates than in standalone firms.

The research findings are relevant to project managers, investors, regulators, lenders, financial institutions and academics in several ways. First, this study can help businesses, academics and government entities to understand corporate investment behaviour and ICFS. Second, this study will make business enterprises aware of the need for ESG and concentrate on the consistent performance of ESG aspects. Third, loan agencies, investors and stakeholders should pay close attention to the company’s ownership structure (group vs standalone) aspect. Fourth, the regulator needs to implement the right policy changes, such as low-interest rates, hassle-free investment, easy access to external funds etc.

The study focused exclusively on manufacturing companies, providing valuable insights into this sector’s investment decisions. However, future research could be expanded to include service companies operating in different environments and facing distinct challenges and opportunities in their investment decision-making processes. Incorporating service companies into future studies could offer a more comprehensive understanding of investment behaviors across various industries.

In addition, future research could explore cross-country analyses to deepen insights into the subject. This approach would allow for the examination of how different economic, cultural and regulatory contexts influence investment decisions. By comparing firms from different countries, researchers could uncover unique patterns or commonalities in investment behavior, which would further enrich the existing literature.

While this study used quantitative financial data drawn from companies’ financial statements, we acknowledge that many qualitative factors could also significantly impact a firm’s investment decisions. Variables such as the personal attributes of the project manager and CEO, leadership style and the specific nature of the investment projects themselves could play an important role in shaping these decisions. Future research could incorporate such qualitative factors to provide a more holistic understanding of the decision-making process within firms. Furthermore, small and medium enterprises (SMEs) are vital to the country’s economic development. Future research can explore the ICFS in the SME context.

Finally, although this study considered overall ESG performance, future work could benefit from analyzing each ESG component individually. By examining the ESG factors separately, researchers could understand how each component influences investment decisions. This more detailed analysis would contribute to a richer body of literature on the role of ESG factors in corporate decision-making.

“The authors would like to acknowledge the efforts of the editor and the anonymous reviewers in improving the quality of this paper in order to make it appropriate for publication. Further, the authors acknowledge the help of Mr. Himansu Sekhar Sethi, Mr. Asis Kumar Sahu, and Mr. Shreetam Dash in the research process.”

Funding: “The authors have received no financial assistance for the research, authorship and/or publication of this article.”

Competing interests: “The authors declare no competing interests in this paper.”

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Table A2