Financial Ratio And Corporate Failure Prediction Accounting Essay


Basically, ratios are tools to help the analyst, investors or shareholders to analyze the performance and condition of the business. The variable used by prior researchers computed from income statement and balance sheet items. This is due to the information easily can get from the published annual reports. But, the used of ratios in business should take into consideration of economic situation and also the business condition whether the business just started the operation, achieving the business growth or achieved the maturity. In addition, the ratio also would be different from one industry to other industry.

Lately, there are many issues in accounting irregularities and that result in corporate failure. The collapse of Enron and Worldcom in US, had give big impact to many group and attract the attention of many parties. In Malaysia, the financial scandal of Transmile Group Bhd in year 2007 also create attention as well as increasing the numbers of analyst including the creditors and banker officers. In other way, the analysts will use ratio analysis and best decision making in prediction of the probability of the corporate failure or performance. Ratio analysis been used as basic analysis by them (including stakeholders) in prediction the performance of the company. But, many researchers used the ratio analysis as a tool to predict the corporate failure since late of 1960s (Beaver, 1966 and Altman, 1968).

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In general, there is wide meaning of corporate failure. Mac Millan English Dictionary defined failure as sudden loss of particular quality or ability especially in a difficult situation (pp. 496). According to Dimitras, Zanakis and Zopounidis (1996), they defined the failure term as a situation where the company cannot pay the lenders, suppliers and became bankrupt. Hence, failure also refers to the discontinued business operation. Also, stated by Mc Gurr and DeVaney (1998), the business failure is related to liquidation, bankruptcy and other legal ceased business operation.

2. Discussion

Most of the researchers using ratio information to predict the business failure. For example, Altman (1968), Beaver (1966), Deakin (1972) and Taffler (1982) used multiple discriminate analysis method to predict business failure. The basis of the methods known as it is able to differentiate ex-post basis between firm which classified as failed and non-failed firms eventhough it is descriptive in nature (Taffler, 1982). Frequently, the coincidence of corporate failure can be connected to fraudulent financial reporting (Kaminski, Wetzel and Guan, 2004). This is because, when the company ceased the operation or stopped the business line, the management that consist of directors would be blamed all the losses. But, in their research they group their target sample into two, which known as fraud and non-fraud firms.

2.1 Why to predict the corporate failure?

Fundamentally, the models or tools are been used to predict the business failure are ratios as well as intelligent and ability decision making. Dimitras et al, (1996) emphasizes two important ways why the stakeholders (consist of shareholders, lenders, suppliers, clients and government) to predict the business failure. Firstly, as a 'signal' to them and take corrective action in preventing the business failure. They can take immediate action and able to continue the business operation with better management. Secondly, it is useful to them in decision making process. These models would help them such as in acquiring another company or when they want to invest in. Furthermore, the creditors and investors will more likely be interested in a company that has sound financial planning and future benefit performance rather than failure in next couple of years.

While Libby (1975), evaluated the accounting ratios and the ability of bank officers in conjunction with business failure prediction. He found that the selected accounting ratios are very useful in determining reliable prediction of business failure. In today's environment, the bank officers are more rigid and strict in giving loan to the companies which do not meet their certain percentage or requirement standard. The bank officers will look out the company's profitability and leverage. They want to know whether the company have the ability to pay back the amount (loan) including the interest in specific time.

2.2 The relationship between financial ratios and corporate failure

There are various variables that can be used to predict the corporate failure. Different researchers selected different financial ratios and Altman (1968) used five variables in order to predict corporate financial failure, which can be classified into five categories; liquidity, profitability, leverage, solvency and activity ratios. The consideration in selecting these five ratios is based on the popularities in literature and potential to the relevant study. The five ratios are working capital/total asset (WC/TA), retained earnings/total assets (RE/TA), earning before interest and tax/total assets (EBIT/TA), market value equity/book value of total debt (E/TD) and sales/total assets (SAL/TA).

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Furthermore, Dimitras et al, (1996), stated that most of the researchers used solvency ratio (e.g. WC/TA and TD/TA) to determine the prediction of business failure. Another ratio that widely used is profitability ratio to measure the position of the company in term of profit making. While, Johnson (2002) emphasize that there are some techniques and guidelines to assist in evaluating the financial ratios of company and competitors. There are five selected measures to compare on with the data namely liquidity (current ratio and quick ratio), debt lead and debt coverage (total debt/total long term debt), tangible net worth (current liabilities/tangible net worth), bankruptcy risk (net working capital/total assets) and efficiency (management rate of return).

In addition, research done by Kaminski et al., (2004), out of 16 ratios that seems to be significant, only five ratios that significant to the research which are; account receivable/total asset (AR/TA), cost of goods sold/sales (COGS/SAL), fixed asset/total asset (FA/TA), interest expense/total liabilities (IE/TL) and sales/account receivables (SAL/AR). While, Libby (1975) chosen five ratios out of 14 ratios set which can be grouped by profitability, activity, liquidity, assets balance and cash position. These five ratios represent net income/total assets (EBIT/TA), current assets/sales (CA/SAL), current assets/current liabilities (CA/CL), current assets/total assets (CA/TA) and cash/total assets (CAS/TA) respectively.

Taffler (1982) stated that retail industry highly vulnerable to corporate failure on late 1990s. Thus, he focused only specific industry (retail industry) and used five models from previous studies including two financial ratio model that can be grouped in to four; leverage or management ratio, liquidity ratio, profitability or efficiency ratio and market value ratio. Sometimes, the corporate failure can be caused by other influenced factors such as environment and market trends which financial information cannot predict the failure of the company within that difficulties time (Dimitris, 1996).

Thus, ratios that most related and to measure corporate failure are leverage ratio and liquidity ratio. This also supported by Estrella, Park and Peristiani (2000), which used leverage ratio and gross-revenue ratio to predict bank failure. Overall, the usefulness of financial ratios may varies and depending the type of business operation either trading, service or special industries.

2.3 Financial ratio, corporate failure and fraud

Financial ratio also can be related to financial fraud. It clearly define that the failure or collapse of the company, it can be due to the poor management, mismanagement or fraud by the top management. In addition, the company also may adjust the financial ratios to meet the predetermine target like industry average means (Lev, 1969). For example, the manager may shift or adjust the term of credit sales to increase the current ratio. Morelikely, the management of the company had done income smoothing of the financial statements. Therefore, in order to combat fraud, effort by various parties such as management of the business, external auditors and also employees should be taken into consideration. But in reality the ratio analysis hardly gives much impact for fraud detection because only few studies done to compare the ratio analysis between fraudulent companies with none- fraudulent one. Somehow for the users of the financial statements can rely on the fact the financial ratio give a glimpse on the financial position of a particular company. Though it might not really show the whole true financial position, it does have the snapshot of what is really happen in the company.

The detection of fraudulent financial reporting using financial ratio come from varies researchers. Research done by Kaminski et al., (2004) is to determine the ability of financial ratios in identify the financial fraud in accounting data. They want to know is there any relationship exist in ratio analysis and financial statement of fraudulent firm. Somehow, the finding provides that auditor cannot depend on the ratio analysis only in order to detect financial fraud.

Moreover, Lev (1969) also stated that the speed of adjustment (ratio adjustment) which rationalized by most of the economist, relate two types of cost; the cost of adjustment and the cost of being out of the industry mean. The cost of adjustment is a quick adjustment of financial ratio to get the target such as current ratio. Current ratio involves short term item and directly under control of management. Thus, this item can easily be adjusted to meet the target ratio and not too difficult compared as other ratios. While, the cost of being out of the industry mean reflect the importance of the company to achieve as same as industry norm of 2:1. For example, the bank officers would released the loan to the company which have 2:1 current ratio but it is depends on the industry norm itself, because different industry have different industry norm.

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So, it can be prove that, short term items which related to the current ratios easily be adjusted to meet the predetermine target and 'window dressing' in the financial statements. Hence, the management report untruthful information to the shareholders as well as to the stakeholders of the company.

2.4 Limitations of financial ratio

Besides that, Frecknall-Hughes, Simpson, and Padmore (2007) noted that there are some limitations of financial ratios in small and medium sized enterprise (SMEs). First, ratio analysis is meaningless if the company generated loss. In SMEs company, losses is not bad sign to them but if for public listed company, the losses represent poor management and as an investor it is definitely bad sign to them. Next, ratio analysis deals only with financial numbers and does not take into consideration of other factors which may affect company performance or corporate failure. Normally, ratio analyses computed from publish annual report but for SMEs it is difficult to get the primary data. Thus, the ratio analysis may varies from one business to another. Also, ratio analysis not explained the reputation of the company, for example, changes in management or supporting services, eventhough it would slightly affect the profitability of the company.

This supported by finding of Kaminski et al., (2004) emphasize that the limited ability of financial ratios in detecting of financial fraud. They stated that only selected ratio consistently significant to prior and during the fraud year. It is difficult to detect the financial statement fraud using financial ratios because only standard setter and auditors can prescribe the useful of ratio application and analysis in order to detect the financial reporting fraud.

Although the financial ratios had their limitation in prediction performance or corporate failure, but until today it has been used by most of the analyst around the worlds. The limitations of financial ratios could not prevent the investors, other analysts and researchers from used in their research papers as well as wider the used at higher levels.

3. Conclusion

In early 1960s, the researchers used such ratio analysis to predict the corporate failure before the collapse of Enron and Worldcom. This showed that the ratio analysis been widely used long time ago and still can be used until today. The most encountered financial ratios while predictions of the corporate failure are working capital/total assets (WC/TA) and total debt/total assets (TD/TA) (Dimitras et al, 1996) and the most categories used are liquidity, solvency and profitability. At the mean time, the company with high debt ratio always faces high risk. The company with high debt ratio will be faced cripple corporate budget and difficulty in paying the interest if the managers cannot manage it properly. Moreover, debt financing also sensitive to interest rate fluctuation and cannot be predicted (Johnson, 2002).

Today, due to the uncertain world in economic position and the management of the company, the usefulness of financial ratios only to predict the business performance or failure cannot be depended. It is because the limited ability of the ratio analysis in determining the performance or failure prediction of the company or detecting of the financial fraud (Kaminski et al, 2004). It should include the non-financial or qualitative information in order to measure the business performance or to predict the business failure. Thus, the investors should not only rely on financial ratio analysis but knowledge about non-financial also should be used to help in decision making ability and valuation of company's performance (Beaver, 1968). For example, the analyst or stakeholders may used semi-strong form of efficient market hypothesis that refer to the historical information together with any publicly known information such as newspapers, internets and other related sources like current issues and economic condition. Besides, the potential investorsalso are aware and cautious in selecting the companies to invest in. They are precisely and fastidiously about investment and hope to make profit from the money that they invest in.

In conclusion, there are some lessons that the management should look into consideration from financial scandals issues whereby everyone in the business world must act honestly and perform due diligent in performing their duties especially for Board of Director and executives in the company. This to ensure that the company can operate the business for longer years and safeguard of the shareholders' investment.