Predicting Bankruptcy: If Cash Flow’s Not the Bottom Line, What Is?

Abstract

Analysts are continuously searching for techniques or models that can successfully judge the condition of a company 's health and thereby reduce forecasting errors and improve predictive performance. Various financial ratios have traditionally been used to classify failed and nonfailed companies. But the addition of cash-based funds flow components to traditional ratios can provide superior results in the prediction of financial failure. In particular, the dividend, investment and receivables components of funds flow provide significant information about a company's financial health. Having never been identified in prior ratio studies as significant factors in explaining bankruptcy, these funds flow components may supply unique information to the examination of corporate financial health. Dividends and investment, of course, represent cash outflows for a company. For healthy companies, receivables also represent outflows. One implication of this finding is that outflow components are more closely related than inflow components to the explanation of financial failure.