Share this story
Close X
Switch to Desktop Site

One bankruptcy barometer is challenged by the experts

Signs of recovery may be cheering the economic mood in America, but record numbers of companies are still skidding into bankruptcy. And as the bankruptcy tally intensifies, so does the attention of the creditors, analysts, and investors who have a stake in these businesses.

The popular analytical tool being used by these people to gauge the financial strength of a company is not as accurate as is generally believed, says Cornelius Casey, an associate professor of business administration at Dartmouth's Amos Tuck School.

About these ads

In the last 10 years or so, a lot of emphasis has been placed on a company's operating cash flow as ''the ultimate determinant of how well a company is doing ,'' Mr. Casey explains. ''But what surprises me is (its) low level of accuracy, '' he says.

Mr. Casey says more analysts have drifted away from looking at earnings to looking at operating cash flow - a practice that goes by the arcane name of ''cash-flow analysis'' - as a major indicator of financial strength. The earnings picture doesn't tell the whole story, he says, because of inflation and because by ''using imaginative financial reporting, companies are able to beef up their earnings.''

He hopes to convince analysts that ''cash flow is not the final word'' - that other variables such as a business's indebtedness, profitability, liquidity, and turnover (its ability to turn its current assets into cash) need to be considered.

Cash-flow analysis became popular because ''it's a simple model - just cash coming in and cash going out,'' says Paul Miller, who is looking into cash flow for the Financial Accounting Standards Board, a private body that sets the rules commonly used by the accounting profession. ''With cash flow there is no chance to defer, postpone, or pull (figures) out of another period the way you can sometimes do with earnings,'' he says.

And Richard Smith, vice-president for corporate ratings at Standard & Poor's Corporation, says, ''We believe (cash flow) is one of the most important analyses we do. Not because it's easy and quick, but because it's better. The ability to generate cash flow is the whole ball game - if you can't do that, there's no reason to stay in business.''

For the last year and a half, Mr. Casey and a colleague, Associate Prof. Norman Bartczak at Harvard Business School, have tested various operating-cash-flow models against 60 bankrupt companies and 240 related but nonbankrupt companies. The purpose of the test was to see how well cash-flow analysis could predict bankruptcy. The two men also ran tests on the companies with their own model, which takes into account other variables besides cash flow. The list of failed companies included Braniff International, Wickes, Saxon Industries, Lionel Corporation, and W.T. Grant.

The best results they could get from running an operating-cash-flow model was to be able to predict 67 percent of the bankruptcies one year before they occurred. Two years before bankruptcy, the cash-flow model could only predict 58 percent, and three years before failure it predicted 50 percent.

About these ads

On the other hand, the model developed by Casey and Bartczak was able to predict 85 percent of the bankruptcies one year out, and 80 percent of them two years before failure. ''With two years to work with, a company could do something'' to get off the bankruptcy path, Casey says.

The purpose of the study wasn't to tout their model, which is based on a number of other models being used by financial analysts today, Casey says. There had been no empirical evidence to prove the accuracy or inaccuracy of cash-flow analysis to predict bankruptcies. Their tests were intended simply to provide that evidence, he explains.

''This doesn't say the operating-cash-flow measure isn't good for anything,'' he adds. For instance, it can be very helpful in sizing up a company for takeover, he adds.

But many analysts aren't just looking at operating cash flow to get the picture for the future, says Edward Altman, a leading authority on bankruptcy and author of a new book, ''Corporate Financial Distress'' (John Wiley & Sons, New York, $29.95).

''Analysts look at a whole host of things,'' Mr. Altman said in a phone interview. ''Credit analysis has become far more sophisticated'' because of the increasing number of business failures. ''I don't think you could say cash flow is most popular.''

And although ''cash flow is a very good predictor,'' states Standard & Poor's Mr. Smith, ''it's not the only one by far'' and it's not the only one he uses to forecast bankruptcy.

Follow Stories Like This
Get the Monitor stories you care about delivered to your inbox.