Financial health or insolvency? Watch trends and interactions in cash flows.

Foster, Benjamin P. ; Ward, Terry J.

INTRODUCTION

Many firms face financial difficulties at some time. Once facing the initial problems, however, some firms regain financial health while others slide into distress that leads to an inability to pay debts as they come due (insolvency). What distinguishes firms that remain healthy and those that eventually become insolvent? More and more, analysts are looking at cash flows to answer that question. This study examines the usefulness of information provided on the cash flow statement to determine if cash flow trends and interactions indicate whether or not a firm will eventually become unable to meet its financial obligations and/or declare bankruptcy.

CASH FLOW INFORMATION IN THE FINANCIAL STATEMENTS

In Statement of Financial Accounting Concepts No. 1 (par. 37) the FASB noted that a goal of financial reporting is to provide information to help users assess prospective net cash inflows. Financial statement users, accountants, and the FASB noted that cash flow information should help investors and creditors predict future cash flows. In SFAS No. 95, the FASB required disclosure of additional cash flow information by replacing the statement of changes in financial position with the cash flow statement. The FASB stressed the importance of trends and interactions among the types of flows in SFAS 95: flows from investing, financing, and operating activities. When a firm faces financial difficulties, investing, financing, and operating flows can indicate how management is attempting to deal with the difficulties. However, accounting researchers have ignored the trends and interactions in cash flows and have primarily examined only cash flows from operations.

CASH EQUILIBRIUM, CASH FLOWS, AND FINANCIAL DISTRESS

Financial distress is often defined as insolvency, the inability to pay obligations as they come due. How much cash-on-hand the company maintains, how the company obtains cash, and where it spends cash can indicate whether a company remains financially healthy or becomes distressed. Cash flow theory states that a firm achieves financial health and stability by maintaining an equilibrium in cash flows where available funds equal the firm's cash needs. (See an article by Ward, 1995, for a complete discussion of cash flow theory.) These issues were originally considered in ARB No. 37, issued in November, 1948. However, ARB No. 37 was revised in 1953 to include consideration of stock purchase plans and recast as Chapter 13B of ARB No. 43. Events triggering an unexpected drop in cash flow can upset cash flow equilibrium and force a company to take corrective action. Events causing the drop in cash flow include a recession and resulting decline in sales, price or wage increases, increased competition, and management behavior.

Cash flow theory suggests that losing cash equilibrium creates financial stress on the firm. The way management tries to restore cash flow equilibrium dictates future cash flows. Managers attempt to regain equilibrium by: borrowing money or issuing capital stock, cutting dividends, cutting costs, or liquidating assets. If equilibrium is not regained, the firm progresses through more severe stages of stress and may become unable to pay financial obligations. At each stage, management attempts to take appropriate action to regain cash equilibrium. Management's success dictates whether a firm recovers or progresses toward eventual insolvency.

Because the strategies managers can pursue affect different types of cash flows (operating, investing, and financing), information from the cash flow statement may indicate what stage of financial stress a firm is in, and provide information about management actions to regain cash equilibrium. Cash flow theory indicates that the trends in the three gross cash flows and interactions among these cash flows provide insight into a firm's future solvency. However, researchers have primarily looked at the three cash flows separately and have not placed emphasis on their trends and interactions. Thus, results from research testing the usefulness of cash flows have been somewhat disappointing; only cash flows from operations has shown consistent usefulness in predicting insolvency.

INFORMATION ANALYZED

To study the ability of trends and interactions of the three gross cash flows to provide insight into future insolvency, we compared cash flows from firms that became insolvent to cash flows from matching solvent firms. To develop our sample, we defined insolvent firms as those that either declared bankruptcy, missed debt payments or received favorable debt accommodations in 1990, 1991, or 1992. We then randomly matched these firms with firms from the same industry that did not experience insolvency. The final sample included 114 insolvent firms and 264 matched solvent firms.

We examined financial information from the firms three, two, and one year prior to the distress event. Thus, the analysis included information from: (1) 1987, 1988, and 1989 for 1990 firms; (2) 1988, 1989, and 1990 for 1991 firms; and (3) 1989, 1990, and 1991 for 1992 firms. The analysis only included information for three years prior to insolvency because we examine the actual cash flows presented on the statement of cash flows, not estimated cash flows as used in previous studies. The earliest data we analyzed came from 1987, the first year all firms prepared statements of cash flows.

Because cash flows are the focus of this study, the analysis included the following variables as a percentage of operating assets: (1) cash at year end; (2) cash flows from operations (CFFO); (3) cash flows from investing (CFFI); and (4) cash flows from financing (CFFF). The U.S. entered a recession in 1990. Consequently, results in this study reflect firms' management of cash flows while entering difficult economic conditions.

RESULTS AND DISCUSSION

Table 1 presents the variables' means for the healthy and insolvent firms. The means indicate differences between the two groups for all three cash flows. However, the means by themselves are stagnant in time and do not tell the full story. Plotting the means across time can reveal important trends and interactions among the cash flows. Figures 1 through 4 show the trends in cash items as a percentage of operating assets for the healthy and insolvent firms. Figures 2 through 4 plot the means for each cash flow separately across three years. As one would expect, Figure 1 reveals that healthy firms maintain a higher level of cash than insolvent firms and that insolvent firms exhibit a declining cash percentage. In Figure 2, the healthy firms show a positive CFFO while the insolvent firms show a declining, negative CFFO.

Figures 3 and 4 reveal some interesting trends as the distressed firms approach their insolvency date. Figure 3 shows that distressed firms move from investing in assets (negative CFFI) three years prior to distress, to selling off assets (positive CFFI) one year prior to insolvency. The trend n CFFF for insolvent firms in Figure 4 illustrates the fact that these firms lose their ability to obtain outside funds as insolvency approaches. One year before the event, insolvent firms pay more back than they receive from financing. Healthy firms retain relatively stable investing and financing cash flows in comparison to the insolvent firms.

Plotting the three cash flows together for each group of firms provides more insight into the importance of trends in cash flows. Figure 5 plots the three cash flows across time for the healthy firms while Figure 6 plots the three cash flows across time for the insolvent firms. Figure 5 shows that healthy firms maintain fairly stable cash flow patterns, even during the period preceding a recession. Note that healthy firms' CFFO and CFFF decline slightly from year three to year two, but recover in year one, the year preceding their matched firms' default or bankruptcy. Healthy firms offset the slight drop in CFFO by investing and borrowing less. However, they still maintain an outflow in CFFI and an inflow in CFFF. The key to remaining solvent is stability in the firm's cash flows over time. Management is successfully maintaining cash flow equilibrium. This behavior is consistent with cash flow theory.

Figure 6 plots the trends and relationship among the cash flows of insolvent firms prior to their distress event. These firms have lost their cash equilibrium and are on a collision course with insolvency. The trend for each cash flow is much more severe for the insolvent firms (steeper slopes) than for the healthy firms.

Figure 6 shows that increasingly negative CFFO reduces the firms' ability to obtain funds through financing activities. Consequently, these firms begin to invest less from three to two years prior to the distress event. Less investment results in even less cash generated from operations and further decreases the firms' ability to obtain outside financing. From two to one year prior to the insolvency event, insolvent firms actually must pay more back to outside financing sources than they are able to obtain, generating negative CFFF.

Insolvent firms must eventually sell off long-term assets to pay their financing obligations. However, lack of new investment and selling off existing long-term assets appears to negatively impact a company's operations. (CFFO's negative slope increases between years two and one.) Eventually, CFFO declines to more of an outflow than the company spends on new investment (CFFI), creating an interaction point (interaction 1 in Figure 6). CFFI also interacts with CFFF as the firm loses the ability to borrow additional funds (interaction 2 in Figure 6). As described in cash flow theory, these trends and interactions among/between CFFO, CFFI, and CFFF are the strongest indicators that a firm is headed toward insolvency.

CONCLUSIONS

Comparisons of insolvent firms (those that filed bankruptcy, or defaulted on, or received favorable accommodations on loans) and matching firms reveals differences in cash items. As no surprise, we found that firms that become insolvent maintain a lower cash balance as a percentage of their operating assets in the years leading to the distress event than firms that avoid distress.

Analysis with cash flow variables reveals that the trends and interactions among/between CFFO, CFFI, and CFFF (as a percentage of operating assets) are the most important indicators of whether or not a company will maintain financial health or will become insolvent. Healthy firms maintain somewhat stable cash flows even when entering a recession. However, insolvent firms experience declining CFFO and a diminished ability to obtain funds through financing activities prior to insolvency. Consequently, distressed firms must sell off assets to pay off financing obligations leading to a positive flow from investing activities and a negative financing flow.

These actions by insolvent firms create two interactions. These interactions show that insolvency is likely unavoidable when a company experiences levels of CFFO and CFFF outflows that require offsetting inflows from CFFI. These interactions and trends in all three cash flows provide evidence of future insolvency. The interactions occur approximately one and two years before ultimate insolvency. However, prior researchers have failed to look at these trends and interactions.

This study provides evidence that the cash flow statement and the classification of cash flows by activities can provide useful information. Creditors should carefully scrutinize the credit worthiness of customers exhibiting dangerous trends and interactions in their cash flows. Negative CFFO combined with decreasing CFFF and an increasing inflow from CFFI is a strong signal of impending insolvency. Also, results indicate that accountants should help managers be vigilant in protecting the firm's cash equilibrium. Firms should act quickly to restore equilibrium after it is lost; delay can lead to the death spiral of selling off assets and evaporating credit.

REFERENCES

Ward, T.J. (1995). Using Information from the Statement of Cash Flows to Predict Insolvency. The Journal of Commercial Lending, 77(7), 29-36.

Benjamin P. Foster, University of Louisville

Terry J. Ward, Middle Tennessee State University

TABLE 1: MEAN RATIOS OF HEALTHY AND INSOLVENT FIRMS

 Three Years Prior Two Years Prior
Ratio (1) to Insolvency to Insolvency

 H (2) I H I

Cash % 9.1 7.2 7.9 6.3
CFFO 6.2 -1.4 5.2 -2.0
CFFI -9.9 10.6 -8.1 -4.4
CFFF 4.3 9.3 1.8 5.4

 One Year Prior
Ratio (1) to Insolvency

 H I

Cash % 8.9 4.6
CFFO 5.7 -5.5
CFFI -6.5 0.6
CFFF 2.1 -2.5

(1) Cash % = (cash on hand/operating assets) x 100

CFFO = (cash flows from operations for the year/operating assets)
 x 100
CFFI = (cash flows from investing for the year/operating assets)
 x 100

CFFF = (cash flows from financing for the year/operating assets)
 x 100

(2) H = Healthy firms I = Insolvent firms