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FINANCIAL RATIOS AS
PREDICTORS FAILURE

Nowadays, due to globalization, people can have more opportunities
to conduct their business, investment anywhere around the world. Before making
decisions about investment, investors are always concerned about firm’s
performance. If the firm has a high performance, it will attract people to come
to it. In contrast, with the low performance, this firm must face to
bankruptcy. Therefore, performance measurement plays an important part in
effective measurement of an organization. Performance measures are either
financial or organizational, financial performance such as profit maximization,
maximizing profit on assets, and maximizing shareholder’s benefit at the core
of firm’s effectiveness (Chakravarthy, 1989). According
to its importance, we want to have an insight about this matter.

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Firms are commonly seen as coordinated by intentions and goals. The
purposes of firms and evaluating comparative firm success and failure in
fulfilling those purposes are conspicuous parts of conventional discourse. Firm
performance has been defined as a set of both financial and non-financial
indicators capable of assessing the degree to which organizational goals and
objectives have been accomplished (Kaplan and Norton,
1992). To evaluate a firm’s performance, researchers create many
indicators which have relation with firm’s performance. Based on the purpose of
a firm, they use the indicators that they think it is the most suitable. Until now, there are many financial indicators
that were created. But in many cases, financial
performance is always the center of firm’s performance (Venkatraman
and Ramanujam, 1986). Accounting measures are the most common and
readily available means of measuring organizational performance. Richard et al (2009) found that accounting based
indicators were used in more than 50% of all papers published by the five
leading academic management journals from 2005 to 2007. Then Danielson and Press (2003) found that the correlation
between accounting and economic rates of return was above 0.75 and Jacobson (1987) found that despite a weak R2 of 0.2,
return on investment (ROI) was able to distinguish performance between firms
and over time. All of these show that accounting based indicators such as
financial ratios, which are constructed starting from financial statements, are
very important.

But what are financial measures? Financial measures are one of the
most powerful measures to evaluate organization performance. It was divided
into 3 groups: Profitability, market value, growth (Santos and Brito (2012).
The most commonly used performance measure proxies are return on assets (ROA),
return on equity (ROE), and return on investment (ROI). These accounting
measures are the representing of financial ratios from balance sheet and income
statement. There are other measures of performance called market performance
measure such as price per share to earnings per share (P/E), market-to-book
value (MTB), Tobin’s Q. Growth opportunities are measured by growth of sales. Financial
ratios may be used by managers within a firm, by current and potential shareholders (owners)
of a firm, and by a firm’s creditors.

The most important financial indicators are
financial ratios. Financial ratios have evolved as a
result of Euclid’s analysis of properties of ratios in the book V of his
elements in approximately 300 B.C. The earliest traces of financial statement
analysis are founded in nineteenth century. However, the use of ratios is of
recent development.

During the 1920’s, people were interested in increasing financial ratios.
As a result, many articles were published on the subject of ratio analysis,
more research work emphasize the use of various financial ratios were analyzed.
James. H.Bliss (1923) developed the first
coherent system of ratios and he considered ratios to be the indicators of
status relations within in a company. Although the model and assumption of
Bliss was simple, his study was very promising. From 1930 to 1939, Stock
exchangecommission was created in this period. Hence, there were some external
factors that would affect financial statements’ content. There were two main
evolutionsin this decade related to ratio analysis. The first one was the start
of studies to determine the groups and set of relationshipsbetween ratios (Roy A. Foulke (1931).The second important development
was that several studies about the ability of financial ratios to predict financial
problems in early 1930 the companytook and the authors also tried to use scientific
method to examine the usefulness of ratios. In the 1940s, financialratios
increasingly large number of economic studies as independent variables for
analyzing and describing economic activity. Since 1946 until today, people were
keener on investment returns than administrative purposes. Therefore, some
studies conducted focused on the ability of financial ratios to predict corporate
bankruptcies. William. H. Beaver (1966) used
more complicated and powerful statistical techniques which were different from
previous studies to prove the ability of being predictors of financial ratios. His
study presents a landmark for future research in ratio analysis. All of these
show that financial ratios can be used as predictors, not only just a tool to
review and analyze a firm performance.

We can easily see that all of them were very interested in financial
ratios. But why people use financial ratios to evaluate firm performance? It is
because financial ratios have some advantages. Firstly, they are calculated easily,
financial ratios do not require any additional information beyond the financial
statements. Therefore, once financial statements are completed, these kinds of
ratios can be produced by accounting systems. Secondly, from the information
that financial ratios supplied, we can compare the health of the company to
other companies in the same field and industry standard. Managers also can
compare the information of the company itself to previous periods. After that,
they can modify the company’s policies, strategies to raise their own
objective. However, these ratios also have their disadvantages. One of these
disadvantages is that financial ratios just provide a review of the firm’s performance.
There are many other difficulties that managers have to deal with such as:
eliminating waste, should increase product output in current market situations,
etc. This performance review does not usually require financial ratios. Secondly,
different accounting practices can distort comparisons even within the same company
(leasing versus buying equipment, LIFO versus FIFO, etc.). Hence, we should
combine non-financial information to have an overview about firm performance.
However, in this paper, we want to focus on reviewing 2 main research papers in
2 different periods and other references to make clear about the ability of
financial ratios about predicting failure. We want to figure out whether there
is any difference in each research or not. Even though financial ratios have a
lot of functions, in our paper, we want to concentrate on predicting corporate
failure or not by using various financial ratios by reviewing some empirical
research papers to have a clear picture about using these kinds of ratios as analyzing
a firm’s health.

 

The first study is William
H. Beaver (1966)

William H. Beaver (1966)
was very concerned if financial ratios can be used the prediction of failure
even though these were widespread used as predictors of failure in this time.
He defined “failure” as the inability of a firm to pay its financial obligations
as they mature. The firmshave failed when any of the following events have
occurred: bankruptcy, bond default, an overdrawn bank account, or nonpayment of
a preferred stock dividend. With these purposes, he used Moody’s Industrial
Manual as the source. Moody’s Industrial Manual contains the
financial-statement data for industrial, publicly owned corporations. The
population excludes firms of non-corporate form, privately held corporations,
and nonindustrial firms (e.g., public utilities, transportation companies, and
financial institutions). The firms in Moody’s tend to be larger in terms of
total assets than are non-corporate firms and privately held corporations. The
sample is the final list of firms contained 79 failed firms which financial
statement data could be obtained for the first year to the fifth year before
failure and 12,000 non-failed firms from 1954 to 1964. The firms were
classified according to industry and asset size.

TABLE : LIST OF RATIOS

GROUP I (CASH-FLOW RATIOS)
1.       Cash flow to sales
2.       Cash flow to total assets
3.       Cash flow to net worth
4.       Cash flow to total debt

GROUP IV (LIQUID-ASSET TO- TOTAL-ASSET RATIOS)
1.       Cash to total assets
2.       Quick assets to total assets
3.       Current assets to total assets
4.       Working capital to total assets

GROUP II (NET-INCOME RATIOS)
1.       Net income to sales
2.       Net income to total assets
3.       Net income to net worth
4.       Net income to total debt

GROUP V (LIQUID-ASSET TO CURRENT DEBT RATIOS)
1.       Cash to current liabilities
2.       Quick assets to current liabilities
3.       Current ratio (current assets to current liabilities)

GROUP III (DEBT TO TOTAL-ASSET RATIOS)
1.       Current liabilities to total assets
2.       Long-term liabilities to total assets
3.       Current plus long-term liabilities to total assets
4.       Current plus long-term plus preferredstock to total assets
 

GROUP VI (TURNOVER RATIOS)
1.       Cash to sales
2.       Accounts receivable to sales
3.       Inventory to sales
4.       Quick assets to sales
5.       Current assets to sales
6.       Working capital to sales
7.       Net worth to sales
8.       Total assets to sales
9.       Cash interval (cash to fund expenditures for operations)
10.   Defensive interval (defensive assets to fund expenditures
foroperation)
11.   No-credit interval (defensive assets minus current liabilities to
fund expenditures foroperation

 

 

Using 30 financial indicators which divided into 6 groups as the
Table above, he compared the ratios of failure firm with non-failure firm.
Using a univariate analysis, he tested if the financial ratios can predict the
failure of a firm or not? He found that the ratio distributions of non-failed
firms are quite stable throughout the five years before failure. The ratio
distributions of the failed firms exhibit a marked deterioration as failure
approaches. The result is a widening gap between the failed and non-failed
firms. The gap produces persistent differences in the mean ratios of failed and
non-failed firms, and the difference increases as failure approaches. Also the
cash-flow to total-debt ratio has the ability to correctly classify both failed
and non-failed firms to a much greater extent than would be possible through
random prediction.

Although his
research provided very useful information, it still has some limitations:

1)     
Not all ratios predict as good
as others. For example: The cash- flow to total-debt ratio has excellent
discriminatory power throughout the short-term period. However, the predictive
power of the liquid asset ratios is much weaker.

2)     
The ratios do not predict
failed and non-failure firms with the same degree of success. Non-failed firms
can be correctly classified to a greater extent than can failed firm.

3)     
The result of this research can
be affected in reality. If ratios are used to analysis the financial health of
a firm, managers of firm can make a lot of adjustments to make the health of a
firm better. It’s mean that if the treatment was applied in time, the firm did
not failure.

Despite some limitations, his research opens new ways for future
researchers. People researched more about cash flow and predict bankruptcy by
incorporating cash flow characteristics in their predictive models . Scott (1981) claimed that cash flow variables involve
estimates of the firm’s future cash flow distribution, and that past and
present cash flow should be able to predict. Some people use another indicator
to predict firm’s health. Edward I. Altman, 1968said
that changes in market prices of stocks can also be used to predict failure.

The second study is of
Weiying Guo (2008). The aim of his study was to
present some empirical results of predicting corporate failure by using various
financial ratios with two samples: default and non-default companies of Hong
Kong over the period (2001-2007). He supposed that Hong Kong is one of the
first banking industries who adopted the new banking regulation. Moreover,
there has been no comprehensive bankruptcy analysis in Hong Kong, that’s why he
conducted this research. Unlike previous studies which just used simple methods
to do research such as Beaver (1966) used univariate analysis to compared
failed and non – failed companies and found that’s ratios like cash flow/total
assets, net income/total assets, total debt/total assets and cash flow/total
debt were important indicators of failure in particular. Another example, Alman
(1968) used the multiple discriminant analysis and Z-score model which were
more advanced than univariate analysis of Beaver. The  five accounting ratios he used in the
research were working capital/total assets, retained earnings/total assets, earnings
before interest and taxes/ total assets, market value equity/book value of
total debt, sales/total assets. After adapting these methods, the result was
very accurate, correct prediction was 95%for year one and 72% for year two in
detail. However, Guo supposed that Multiple Discriminant analysis (MDA) of
previous researches have some limited, MDA only provides qualitative
differentiation among counterparties, does not produce probabilities, so GUO choose
logistic regression method to do research. For the first sample selection, he
matched each defaulted company with a non-defaulted company in the same
industry, with similar asset size, and in the same year. In the second sample,
he randomly selected non-failed companies without controlling time and firm
size as the first one to see whether time and industry dummies have any effect
on predicting bankruptcy or not. There are some different and new conclusion of
Guo’s study from previous studies. Firstly, in this study, return on equity
(ROE) is an important determinant of corporate failure, while ROE has not been
used extensively in previous MDA or logit analyses. Secondly, free cash flow
does not seem to be related to default risk for companies in Hong Kong, this is
different from Altman (1968) and Zeitun et al (2007)’s results. According to
his study, as risk managers or investors, they should look at company’s capital
structure, profitability, firm size, and equity returns… . Although Guo’s
research has some improvements in comparison with previous research, it still
has limitations. For example, the dataset was limited (only 30 publicly traded
companies listed in this study as default companies), the author viewed in
short term.

CONCLUSION

In past time, Beaver, in his research, used a univariate analysis to
test each single ratio. But through time, with the development of technology, people
use more models that use a multi-ratio analysis using several different ratios
and/or rates of change in ratios over time, which would predict even better
than the single ratio. Nowadays, researchers can also create more complex
models with the help of a computer with some specialized software like STATA,
etc.

Financial indicators, such as financial ratios not only use to
analysis  the result of a firm business
but also can use to predict one firm’s health. But in our opinions, we should
not only pay attention on financial indicators, but also employed other factors
that non-financial information such as disclosure on corporate governance,
marketing strategy, human resource, outcome sources, customer’s satisfaction…

Because two research paper above and other references, the authors
selected publicly traded firms as a sample to do research. Therefore, we think
that there should be an extension of this topic for future study. First,
interested parties can develop aprediction model for the non-publicly traded
firms especiallysmall and medium enterprises (SMEs) firm , it will be a
valuable andapplicable to develop a prediction model for the SME firmsbecause
may have different characteristics.

              Many papers were based on Western
countries, which were developed countries so may be the results of these
researches were not the same as Eastern countries. There are many developing
countries in Eastern like Vietnam or emerging economies. The difference of accounting
regulations, cultural traditional, behaviors and political regime can be
affected on firm’s performance at difference level than western countries. 

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