Accounting information can be useful in predicting financial performance. It is the way in which the information is used in conjunction with other available information that allows for greater success in the predictions. Also, the predictions may only be short-term future predictions.
The article, ‘Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy’ proved that ratios used as part of a model were extremely accurate in predicting bankruptcy up to two years prior to the actual event. The ‘discriminant-ratio model’ was developed to bridge the gap between traditional ratio analysis and other statistical techniques which had become popular, as at this time there seemed to be a move toward the elimination of traditional ratio analysis in assessing future firm performance. The model sampled thirty-six firms and placed them in one of two groups: bankrupt and non-bankrupt. From this point, balance sheet and income statement data was collected and five ratios calculated and placed in the model calculation. The model was found to be 94% accurate in predicting bankruptcy two years prior to the actual event. This article was important, as it showed that individual ratio measurements take on great significance when integrated with analytical discriminant analysis, but only in the short-term.
The article ‘Are Financial Measures Leading Indicators of Firm Performance’ also indicated that no one ratio is superior in predicting future performance, but rather, if certain ratios are used in conjunction with market information, there may be increased accuracy in predicting short-term future performance.
Financial ratios, as well as any other accounting information, are not as useful when used on a stand-alone basis. Available information must be benchmarked against something, such as industry norms, the economy, and past performance of a firm. All accounting information included in financial statements is open to manipulation, that is another reason it is particularly important to look at all available information regarding a company to try and accurately predict the future. Using one method alone is a recipe for disaster, as this particular ratio or tidbit of information may have been manipulated to enhance current performance. As with any aspect of business, or life in general, there is no exact formula that will predict future performance or actions 100% of the time. There is no magic ratio, or magic sentence in financials that will allow for the rest of the information to be disregarded. Throughout our graduate studies we have been taught to analyze and interpret all different types of information regarding business performance, and in putting together every aspect of what we have learned, we can develop fairly accurate predictions regarding future performance of a firm. We know everything has to work together to be successful, so it is obvious to me that the things that work together should be analyzed together to form a complete picture of the company today and into the future.
Analyzing past accounting information is a great tool that can be used to gauge future firm performance, but only when all information is used together.