Coverage of EBITDA by Operating Cash Flows as a Warning Signal About Forthcoming Bankruptcy Filing
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Jacek Welc, Department of Regional Economics, Wroclaw University of Economics, Wroclaw, Poland.
One of the elements of company’s fundamental analysis is an investigation of the level, structure and trends of cash flows. Negative operating cash flows or cash flows lagging behind earnings are considered a warning signal, suggesting heightened risk of future financial liquidity problems. In contrast, excesses of operating cash flows over reported profits are deemed to confirm the high cash-generating capacity of an investigated firm. In this study the operating cash flows of 87 Polish public companies, in which case a bankruptcy filing was announced in a period between the beginning of 2009 and the end of 2016, are compared to the cash flows of randomly selected non-bankrupt firms. Our research found that failed firms tend to report much higher total operating cash flows than EBITDA just before bankruptcy (in contrast to healthy companies). In contrast, in the next-to-last periods before bankruptcy, failed firms tend to report sub-par operating cash flows. Accordingly, observed excesses of operating cash flows over accounting profits, if not investigated with more scrutiny, may generate a false signal about the ostensibly high cash-generating capacity of a given firm. This is so because the artificial “improvement” of the coverage of profits by cash flows, just before the loss of financial liquidity, tends to be driven mostly by ballooning of unpaid operating payables. Consequently, it is unsustainable (if not accompanied by real improvement of operating efficiencies) and followed by the financial collapse.
Bankruptcy Prediction, EBITDA, Operating Cash Flows, Fundamental Analysis, Credit Risk Analysis
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