USING CASH FLOW TRENDS TO IDENTIFY RISKS OF BANKRUPTCY

By Benjamin P. Foster and Terry J. Ward

At times, almost all companies face financial difficulties. Frequently, management's attempts to deal with the difficulty is revealed through investing, financing, and operating cash flows. A study we did suggests cash flow trends and interactions can help identify businesses that will eventually become bankrupt. Also struggling businesses' cash flow trends and interactions frequently lead to covenant violations and loan defaults one year before bankruptcy, and this is another warning sign of impending bankruptcy.

Cash Flow Analysis

Financial health and stability requires maintaining cash flow equilibrium. Events such as a recession can upset a company's cash flow equilibrium by causing cash flow from operations to drop unexpectedly. Loss of equilibrium forces managers to attempt to regain it by reducing investment or increasing financing activities.

The various categories of cash flow will reveal managers' actions. Issuing capital stock or borrowing money, cutting dividends, cutting costs, or liquidating assets are all methods to regain equilibrium. Successful management actions lead to a recovery of equilibrium, but unsuccessful actions lead to further deterioration of finances and eventual bankruptcy. The difficult question for auditors is how to distinguish businesses that will regain equilibrium from those that will eventually become bankrupt.

Two key items can help to distinguish future bankrupts from healthy businesses: 1) trends and interactions among the three cash flows and 2) stress events such as loan covenant violations and loan defaults. We examined a sample of businesses to see if it was possible to improve going concern evaluations by using these two sources as signals of bankruptcy.

Data Examined

From the Wall Street Journal Index, we identified businesses that declared bankruptcy in 1990, 1991, or 1992. Healthy businesses from the same time period and same industry were matched with the bankrupt businesses. The sample included 82 bankrupt businesses and 264 matched nonbankrupt businesses. We compared the trends in the three net cash flows and interaction among the cash flows of businesses that became bankrupt to the cash flows and interactions of businesses that remained healthy. The three net cash flows include cash flows from operations (CFFO), cash flows from investing (CFFI), and cash flows from financing (CFFF). We also examined the incidence of loan defaults and accommodations and loan covenant violations within the two groups.

The businesses' cash flows were compared three years, two years, and one year prior to bankruptcy. Note that the time period studied includes years in which the economy was entering a recession.

Results and Discussion

Cash flows. Trends in the cash flows may reveal more important information than just a comparison of the average flows for the two groups. Figure 1 and Figure 2 graph the three cash flows across time for the healthy and bankrupt businesses, respectively. Figure 1 demonstrates the stability of healthy businesses' cash flows. The impact of the impending recession may be evident in Figure 1. After a slight decline from year three to year two, healthy businesses' CFFO and CFFF stabilize one year preceding their matched businesses' bankruptcy. Healthy businesses apparently invest and borrow less to offset the initial decline in CFFO, but still sustain an outflow in CFFI and an inflow in CFFF. Figure 1 illustrates that healthy businesses successfully maintain cash flow equilibrium.

The trends and relationships plotted in Figure 2 show that bankrupt businesses lose cash flow equilibrium before bankruptcy. Negative CFFO drains cash and makes financing more difficult to obtain. Notice the severe slopes for the CFFI and CFFF of the bankrupt businesses from year three to year two. Investment by these businesses decreases dramatically from three to two years prior to bankruptcy, and further decreases from two years to one year before bankruptcy. Less and less outside financing is available to fund investments. Note the interaction among the flows between two and one year prior to bankruptcy. CFFF crosses below CFFI and CFFO. As Figure 2 indicates, CFFF becomes negative one year prior to bankruptcy; bankrupt businesses are returning more funds to outside financing sources than they receive from such sources.

Figure 2 shows how all three flows are negative one year before bankruptcy. Obviously, companies cannot continue in business long with all three cash flows negative. At this point, some troubled businesses sell off long-term assets to fund their financing obligations. However, cash flows and trends in the flows will continue to differ for businesses that regain cash equilibrium and businesses that fail to regain equilibrium and become bankrupt.

Loan Defaults and Covenant Violations. Due to deteriorating cash flows, businesses often either violate loan covenant agreements or default on loans prior to bankruptcy. Thus, these events are generally strong indicators of future bankruptcy. In our sample of the 82 bankrupt businesses, 19 violated loan covenants and 31 defaulted on loans.

In our sample, auditors added going concern paragraphs to 90.3% (28/31) of the audit reports on financial statements of businesses that defaulted on loans. However, auditors modified audit reports on the financial statements of only 26.3% (5/19) of the businesses that violated a loan covenant and later became bankrupt. *

Benjamin P. Foster, PhD, CPA, is an assistant professor of accounting at the University of Louisville. Terry J. Ward, PhD, CPA, is an associate professor of accounting at Middle Tennessee State University.

Editor:
Douglas R. Carmichael, Ph.D., CPA
Baruch College