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  Using Single Ratios

Introduction to Using single ratios

Several approaches which attempt to make use of ratios to predict future financial failure have been developed. Early research, that is focused on the examination of ratios on an individual basis to see whether they were bad or good predictors of financial failure. Now, a specific ratio (for instance the current ratio) for a business which had failed was tracked over various years leading up to the date of the failure. This was to observe whether it was probable to say that the ratio had displayed a trend that could have been taken like a warning sign.

Beaver performed the first research in this area. He recognized 79 businesses which had failed. He then computed the average (mean) of several ratios for these 79 businesses, going back more the financial statements of every business for each of the 10 years leading up to each failure of business. Beaver then compared these average ratios with identically derived ratios for a sample of 79 businesses which did not fail over this period. (The research employed a matched-pair design, in which each failed business was matched along with a non-failed business of identical size and industry type.) Beaver found that some ratios depicted a marked variation among the failed and non-failed businesses for up to 5 years prior to failure. This is displayed in Figure below:

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Figure: Average(mean) ratios of failed and non- failed businesses plotted against the number of year before failure

To describe Figure let us take a closer look at graph (a). The diagram plots the ratio, cash flow (most probably the operating cash flow figure, that taken from the statement of cash flows) divided through total debt (borrowings). For the non-failed businesses this stayed quite steady at just below +0.45 over the period. Though, for the failed businesses this was previously well below the non-failed businesses, at about +0.15, even five years before those businesses finally failed. It then refused steadily until, through one year before the failure, it was less than -0.15.

Note: the scale of the horizontal axis depicts the most recent year before the actual failure (Year 1) on the left and the initial one (Year 5) on the right. The other graphs in Figure depict an identical picture for five other ratios. In each case there is a deteriorating average ratio for the failed businesses because the time of failure approaches.

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