The Relationship Between Cash Flow from Operations and Bankruptcy

Cash flow from operations (CFO) is an important component in the statement of cash flows. It is viewed by the Financial Accounting Standards Board and many users of the financial statements as a good indicator of whether a company will be in financial distress (i.e. bankruptcy). Previous studies have explored the bankruptcy predictive ability of CFO to show that the above view is only based on intuition and not empirical study. Therefore, overreliance on CFO rather than traditional financial ratios will lead creditors and investors to make wrong decisions. The purpose of this study is to reexamine previous researchers' findings that although CFO can serve as an indicator of whether a firm will be bankrupt, it does not predict bankruptcy as well as traditional financial ratios. In addition, CFO does not even have marginal predictive ability when included in a prediction model containing traditional financial ratios. Compared to previous research, this study uses the most recent data. It focuses only on three major industries: manufacturing, wholesaling, and retailing industries. A sample of 36 bankrupt companies and 36 nonbankrupt companies is analyzed using Wilcoxon Rank Sum Test and Multiple Discriminant Analysis (MDA). The results indicate that CFO variables - CFO, CFO/CL (Current Liabilities), and CFO/TL (Total Liabilities) are statistically significant different between bankrupt and nonbankrupt firms for the first and the second year prior to bankruptcy. CFO variables can serve as a predictor of whether a firm will be bankrupt; however, their predictive ability is mediocre. They do not predict bankruptcy as accurately as traditional financial ratios. In fact, their predictive ability with respect to bankruptcy is much worse than that of the financial ratios. This study also finds that CFO variables contribute little or no significant marginal predictive value when used together with traditional financial ratios for the first and second years prior to bankruptcy. In other words, this study strongly substantiates the findings of previous research.