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The value of operating cash flow in modelling credit risk for SMEs

Small- and medium-size enterprises (SMEs) play a fundamental role in the economic performance of major economies especially in the light of the new Basel Capital Accord. Several lending communities proposed to treat SMEs as retail clients to optimize capital requirements and profitability. In this context, it is becoming critically important to have a detailed understanding of its risk behaviour for appropriate risk pricing. Evidence pertaining to SME financing strongly motivates us to believe that firms which are unable to generate sufficient operating cash flow (OCF) are more susceptible to bankruptcy. However, the role of OCF in bankruptcy of SMEs lacks empirical validation. We are the first to investigate the role of OCF information as predictors in assessing the creditworthiness of SMEs. 1-year distress prediction model developed using significant financial information of UK SMEs over a period 2000 to 2009 confirms that the presence of OCF information does not improve the prediction accuracy of the distress prediction model.