The significance of cash flows in corporate distress. (1991)
AuthorsSharma, Divesh Shankarshow all
Despite increasing research into the development of failure prediction models, corporate bankruptcies continue. The objectives of this study are thus twofold; (1) to expound the limitations of existing failure prediction models and (2) to investigate the significance of a proposed variable, cash flow information, for identifying corporate failure. The construction of cash flow statements up to five years prior to failure for nine distressed New Zealand companies facilitated the development of fifteen cash flow ratios utilised in the analysis. Evaluating the value of cash flows against accrual information followed a brief history of each company eliciting major events leading to its demise. The analysis suggests that cash flow analysis provides significant information for assessing corporate distress, credit worthiness, portfolio management and performance analysis. Six valuable and unique characteristics of cash flow information; key to survival, relevance, wealth maximisation, unambiguous, least susceptible to manipulation and externally valid, contributed to its predictive ability. The study also demonstrates that cash flow information is significantly distinct from earnings and the more traditional definitions of cash flow, namely, net income plus depreciation and funds from operations. A major implication of this poor correlation questions the validity of conclusions of prior studies claiming to have investigated the information content of cash flows.