Accounting Information and Predicting Financial Performance
Financial ratios are often relied upon as a leading indicator of future financial performance by businesses. These accounting ratios and other company specific accounting information can be especially good predictors in the short run, but as the time horizon extends beyond a few years, these metrics lose predictive value. There are simply too many macro and external factors that the hard numbers cannot account for over the long-run.
One way in which these accounting ratios have been tested with regards to predicting future financial performance is by back testing firms that entered bankruptcy. In his study of
Italian corporate firms over a 3 year periods, Marco
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As the company continues to struggle, the terms become more unfavorable and it becomes increasingly difficult to overcome the cost of financing the debt. It becomes a question of cause and effect; did the reliance on debt cause the company to fail or did an already failing company cause a reliance on debt? From the standpoint of a potential investor it does not particularly matter as long he or she realizes that a high debt ratio is a bad sign, unless there is an obvious reason for the company to take on debt to finance future profitable business lines. Research studies in the area of the predictive value of accounting ratios often use a three year time horizon to evaluate these metrics. This appears to be the accepted limit of the usefulness of such ratios. The overall health of the economy, strategic focus of a company, and level of competition become more statistically volatile as time goes on. Investors should never rely on one source of data when committing capital, but financial ratios are a good start, as long as they are adjusted over time when evaluating a potential or existing investment.
Lakshan, A. M. I., & Wijekoon, W. M. H. N. (2013). The use of financial ratios in predicting corporate failure in Sri Lanka. GSTF Business Review (GBR), 2(4), 37-43. Retrieved from