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Accounting Information and Predicting Financial Performance

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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 Muscettola used 32 accounting ratios to test the ability of those ratios to forecast future defaults. The two groups of ratios he found to be most predictive were capital structure ratios and debt coverage ratios. This is a logical conclusion as these ratios focus on liquidity and the ability for a company to meet its future obligations. The capital structure ratios evaluate the various ways a company uses debt to create assets by dividing long-term liabilities, debt, and payables by total assets to assess leverage.
Debt coverage ratios seeks to evaluate the cost of financing by measuring interest expense as a percentage of total debt and sales and evaluate how total debt compares to sales and current liabilities. Muscettola surmises that it is unwise for investors to focus on profitability because it can be misleading and has little predictive value going forward. Instead, he advises to focus on a company’s asset/liability mix and overall reliance on debt to fund operations.

In a similar study of Sri Lankan companies, Lakshan and Wijekoon tried to isolate which accounting ratios were predictive of corporate failure. They

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