Using Cash Flow Ratios To Predict Business Failures

The primary objective of this study was to assess the usefulness of cash flow disclosures as required by Statement of Financial Accounting Standards No. 95 in the prediction of bankruptcy, and whether cash flow data provide a superior prediction of business failure over the models employing conventional accrual accounting data. An empirical study was made of 33 failed firms and 33 nonfailed firms for a five year period. Eight ratios from cash flow data and six ratios from conventional accrual accounting were used in the final models. The conclusions were that (a) cash flow data provide a superior measure for the prediction of business failure over accrual accounting data, and (b) the use of cash flow data in conjunction with accrual accounting data improves the overall predictive power of accrual accounting data alone. The models used in this study may help users of accounting information to detect the deterioration of a firm's financial position. Management may use this information to take the necessary action to avert a potential failure. External users may use the information to make better decisions regarding their current and future investments.