1. Strebel and Andrews (1977)
The detailed studies of Beaver and later Altman, suggested that failure, or bankruptcy could be predicted with significant levels of confidence. Such studies inspired the South African research team of Strebel and Andrews to simplify the relative complexity of the detailed, international analyses to date. It was Beaver's detailed 1966 univariate analysis that first isolated the 'Cash flow to total debt' ratio as been the best predictive ratio. The USA research established the predictive power of 30 traditional ratios, and concluded that the more common ratios, such as the acid test, or debt/equity ratio, turned out to be short term predictors, whereas, cash flow to total debt had predictive power for five years prior to bankruptcy (Strebel and Andrews, 1977:3). Cash flow to total debt correctly classified 90% of companies one year before failure, 82% two years before failure, 79%
three years before, 76% four years before, and 78% five years before. Peter Feinberg, in his article in 'Buinessman's Law', on 'Predicting business failure-the auguries of impending collapse' (1994), claims "the most reliable single augury of business failure is the ratio of cash flow to total debt".
The cash flow to total debt ratio reflects the ability of the company to repay its outstanding liabilities. According to Strebel and Andrews, "cash flow represents annual funds from operations after taxes, interest, and lease payments, or net profits after taxes adjusted for non-cash items (such as depreciation), and excludes all non recurring extraordinary items". Total debt includes all long and short-term borrowings plus current
liabilities, excluding net worth,
Quite simply, according to Strebel and Andrews (1977), "a company with a ratio of 0.33 could payback its liabilities within an average period of three years". The inclusion of the short term borrowings along with current assets gives the model a more realistic picture as companies about to go bankrupt normally extend their overdraft facilities, factor their debtors book and generally show problems in the areas of short term finance (Strebel and
Andrews, 1977:1).
Initially the usefulness of the cash flow to total debt ratio was shown by Strebel and Andrews when they applied it to a local company 'Glen Anil'whose cash flow in 1972 had dropped to 10% of total debt. This ratio reflected problems four years before the companies demise and Strebel and Andrews speculate as to the difference that could have been made in this company failure had the ratio, cash flow to total debt, been widely monitored in the seventies (Strebel and Andrews, 1972:2).
From an initial sample of 16 failed companies and 13 nonfailed companies, Strebel and Andrews concluded that the average cash flow to total debt for nonfailed companies, since 1971, has averaged around 18%. The ratios for failed or potential to fail companies has fallen away from this average at least two to three years prior to failure (Strebel and Andrews, 1977:4). Fourteen of the sixteen failed companies had a cash flow to total debt ratio of less than 5% one year before failure, and thirteen of the sixteen failed companies could have been isolated two years prior to failure using an 11% cut-off (Strebel and Andrews, 1977:5). The pilot study suggested the following guidelines for outsiders who use this ratio to analyse failed or nonfailed firms (Strebel and Andrews, 1977:7):
□ Cash flow to total debt below 10% is a symptom of potential bankruptcy.
□ Cash flow to total debt below 5% indicates a high probability of bankruptcy.
a A slow trend downwards for three consecutive years is indicative of eventual
collapse.□ Creative accounting may be causing a fluctuation in the ratio.
a A "precipitous fall" is a strong indicator of eventual collapse.
Conclusion
Strebel and Andrews stress in their conclusion on their findings, "While the ratio suggests that 9 out of 10 companies with cash flow to total debt of less than 5% will fail within a year, the ratio cannot provide an indication of who the one survivor might be. The ratio is not infallible and should be used as an indicator only". It must not be forgotten when relying on quantitative based decision making, that many studies reveal that 93% of business failures are attributed to incompetence and lack of expertise of management.
2. Daya (1978)