Cash flow ratios as a predictor of corporate failure

Abstract

The main purpose of this project was to develop a failure prediction model using cash flow information and multiple discriminant analysis techniques. Specifically, the model tried to show whether cash flow ratios convey relevant and clear information about a company’s corporate health. Using the final accounts of the above twenty firms, seven ratios were calculated using excel computer package. These values were used to develop cash flow model.

Multiple discriminant analysis (MDA) techniques is statistical technique used to classify an observation into one of several a priori grouping dependent upon observation’s individual characteristics. It is used in this study. The study was carried out for firms that had been listed in Nairobi stock exchange (NSE) in the period 1998 – 2005. Our data set consists of 14 companies that are viable from across the industry in Kenya and 6 failed firms, which have been delisted from Nairobi stock exchange in the same period.

Our model included seven variables and yielded an overall correct classification accuracy of 85 percent a year prior to failure. This showed that cash flows give clear and precise information about a corporate health of an entity. The model can assist managers, shareholders, financial institutions, auditors and regulatory agents in Kenya to forecast financial distress.