Ratio Analysis and Cash Flow in Bankruptcy Prediction

The failure of a business firm is an event which can produce substantial losses to creditors and stockholders. Therefore, a model which predicts potential business failure as early as possible would serve to reduce such losses by providing an early warning to these interested parties. This paper has investigated bankruptcy and different models that proved to have the ability to predict a firm\u27s bankruptcy at least three years ahead. All the models predicting bankruptcy successfully used financial ratios as predictor of failure. Altman used discriminate analysis to group firms on the basis of a combination of five ratios. His results were 95 percent effective in selecting future bankruptcies in the year prior to bankruptcy. His model proved to be accurate in predicting business failure at least three years before the actual event. The model based on Beaver was as good a predictor as the other models. His model using cash flow to total debt ratio was able to predict a firm\u27s failure five years ahead. The Evidence indicates that the non-liquid assets measures predict failure better than the liquid assets measure, even in the years immediate before failure. Even though these models were successfully able to predict business failure early enough, their results were not 100 percent accurate. This results in two types of possible errors. Both types of error have their own cost. The cost of misclassifying a failed firm is much greater than that associated with misclassifying a non-failed firm