Relative and Incremental Usefulness of Earnings and Cash Flows in Explaining Values of Distressed Firms

This study investigates the relative and incremental usefulness of operating cash flow and accounting earnings information in explaining the value of financially distressed firms. It extends our understanding of the price-earnings relationship in the context of financial distress. Unlike prior studies of financial distress, we use two different criteria to identify distressed firms. First, financially distressed firms are identified by their ultimate outcomes: bankruptcy, liquidation or merger. Second, financially distressed firms are identified as firms with high probabilities of failure by using the Altman Z score. We use both criteria to gain additional insights and to overcome any limitations from using bankruptcy as the sole criterion of financial distress. As expected, we find that Dechow's results that earnings are more informative than are operating cash flows do not apply to distressed firms. We find that, for firms that terminate in bankruptcy or liquidation, earnings and operating cash flows are not significantly different in their ability to explain value prior to termination. Further, cash flows are unambiguously more useful for distressed firms that are acquired. When the Altman Z score is used, operating cash flows are more useful than accounting earnings in explaining firm value. Our results on the incremental usefulness of accounting accruals are less clear. Accruals are useful for bankrupt firms. But they are not useful for liquidated or acquired firms. When distress is defined using the Altman Z score, accounting accruals do not appear to be incrementally useful