Previous financial performance and prediction of bankruptcy


One important question in corporate finance is whether past financial data informs us of the forthcoming failure of firm and if it does, then how exactly. A quick answer to the “can?” question is that not always. The answer relies on a simple fact that what we did in the past is not necessarily in causal relationship with what happens in the future. For instance, when a company is performing badly today, it might do well tomorrow, if it does not have sufficient funds today, it might have them tomorrow, but also vice versa, if everything is good today, it might be bad tomorrow. So using past data to forecast failure has an important precondition: it is expected that things go the same way tomorrow as they go today.

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A second key aspect to follow is how old is the information we are using. Depending on business and environment it is active in, the frequency to submit compulsory financial reports and the time during which it has to be done after reporting period has become to an end, can vary a lot. It can for instance happen that when we want to get financial statements about a company in May 2012, then the last publicly available information comes from the end of December 2011. As the gap between assessment time and last data provision has expanded to almost 1.5 years, then a lot of things could have happened meanwhile. Derived from previous, up to date data (e.g. a month or two old), would be of great help in getting more accurate results.

So the underlying principles being discussed, what does signal us from financial reporting that things are going downhill or are not as they should be? There are four major instruments based on financial reports to use: figures from financial statements, financial ratios calculated based on previously given figures, changes in financial statement figures and changes in financial ratios.

The following list outlines major aspects to follow from previously mentioned data:

  1. Is there any debt in balance sheet or a company runs only on equity?The usage of debt in capital structure is common and the usage fact itself does not point to higher bankruptcy probability when other aspects are not considered. Still, it can be said that when comparing firms that have other financial figures similar, except the share of debt among capital (debt to assets or debt to equity ratios), then those using more debt witness higher probability of default. A firm not using debt cannot become bankrupt before it starts using some, but contrary a very large share of debt among firm’s capital can point to the fact that company will never be vital again (i.e. it is virtually bankrupt already). When the amount or share of debt in balance sheet increases, an aspect to be studied is that whether a business has (or will have) enough resources to service that debt in the future.
  2. The more liquid assets (i.e. cash, shares and other current assets) we have among total assets in balance sheet, the better. Liquidity in this sense means how quickly assets are convertible to most liquid asset, i.e. cash. Although large share of liquid assets is good, it might not be sufficient to avoid bankruptcy. Namely, an important question is whether there are enough liquid assets to cover maturing liabilities. This can be measured with the help of different solvency ratios (e.g. quick ratio and current ratio, which are calculated by dividing different liquid assets with current liabilities). When quick ratio (cash divided by current assets) has value one, then all current liabilities (liabilities that will mature in a forthcoming year) can be paid at once. Still, very low levels of liquidity and solvency can point to the fact that problems have emerged too far already and something should be done quickly to improve the situation.
  3. Does a firm operate with profit or it witnesses losses? When a business operates with losses, then its reserves are exhausted and continuing so would sooner or later bring to failure. So in this sense both are correct, the larger the losses or their share (e.g. return on sales ratio) become, the larger the possibilities of failure. An important aspect to follow is that profit statement (also referred to as income statement) does not offer the best picture whether a business is on or under the water with its business activities. Namely, profit statement is accrual based and does not provide a view of cash in- and outflows of a company. In this sense it is more valuable to use operating cash flow as a measure. A drop in profitability is also a negative trend that should be paid attention to.

The previously outlined aspects are the most important to follow in financial statements. Still, it should also be paid attention to, what is the position of a company under question among others in the sector. For instance profitability of a business can be low, but other firms in specific industry also witness low values. Also, for instance the share of liquid assets among total assets is small, but actually the specific business processes demands a lot of fixed assets, so given low values can be considered normal.

For accounting different variables in analysis, bankruptcy prediction models have been developed, which sometimes include even two-digit number of different financial ratios. Such prediction models pay attention to a set of variables, as using only one ratio can often bring to misleading results. Still, the limitations of prediction models also come from the limitations of financial data discussed earlier in this article.

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