TRADITIONAL VERSUS OPERATING CASH FLOW IN FAILURE PREDICTION

Abstract

Prior empirical evidence shows that accrual and cash based flow ratios (traditional and operating cash flows) refer to different financial dimensions. This leads to different predictive abilities in failure prediction. The purpose of this study is to analyse the behaviour of failing and nonfailing firms in terms of accruals and deferrals (adjustment entries) to show the distinctive nature of the ratios. This analysis is made conceptually and empirically. The degree and order of the use of adjustment entries is presupposed to depend on four kinds of factors (revenue of expenditure adjustment, direction of adjustment, cost of adjustment, and maximum size of adjustment). The empirical results show that traditional cash flow is a more stable and reliable predictor of failure than operating cash flow. The most important adjustment entries used by failing firms were to decrease inventories and accounts receivable and, in the last phase, to increase accounts payable.

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