Operating cash flow and creditworthiness assessment

Despite the fact that financial distress often occurs because of liquidity problems, most of the models for predicting business failure neglect the informational role of operating cash flow. The aim of this research is to test whether cash flow ratios can improve firm assessment and better predict financial distress. This research relies on a definition of default distinct from what is usually accepted in literature examining failed firms. In this study, default is a situation of temporary financial distress not strong enough to bankrupt a firm or to generate substandard loans and bad debts. The classification of firm as sound or in financial distress has been determined by cluster analysis carried out on a ratio set computed using information from both banks internal records and the Italian Central Credit Registry. The logistic regression analysis is employed to obtain the final model In the literature the business failure prediction model using cash flow is not vast and show conflicting results. This paper gives a contribution to a broader understanding by relying on a different default definition and linking financial ratios with cash flow. The empirical analysis, carried out on an homogeneous sample of 275 small- and medium-sized Italian companies, shows that cash flow ratios, unlike financial ratios, do not have a higher predictive capacity if used separately from financial ratios. Using cash flow ratios with financial ratios can, instead, enhance the performance of business failure prediction models in discriminating between sound and unsound firms even if with a short-term effect.