Financial Ratios, Discriminant Analysis and the Prediction of Corporate Insolvency: Evidence from Indian Information Technology Companies

Abstract

The present paper aims to predict the insolvency of Indian information technology companies. The four different parameters of solvency namely cash flow to total liabilities, total debts to total liabilities, debt to total assets, and equity shareholders’ funds to total assets are used in the current study. These different solvency indicators have been categorized using three numerical values one, two, and three. One indicates those companies which are financially sound, two reflects companies with moderate solvency position, and three indicates weak companies having poor solvency ratios. The different financial ratios are used as a predictor or explanatory variables of insolvency of Indian IT companies. The empirical findings of the study show that there is significant discrimination in the solvency position of companies according to their different financial performance parameters. Since there are three categories of companies as per their solvency position, so two discriminant functions are created and both of these functions are found significant at 5% levels for two parameters of solvency namely, equity shareholders' funds to total assets and debt to total assets. In the remaining two measures of solvency (Debt to total liabilities and cash flow to total liabilities) only a single function is found significant.  Classification results, canonical correlation, and Wilks’ Lambda test confirm the statistical significance of research results. The outcomes of the study will be helpful to policymakers, different stakeholders.  Society will also be benefitted by knowing the critical factors responsible for companies that are likely to become insolvent.