In recent years, the incidence of sickness in Indian in-
dustries has attained a serious dimension. While the
Corporate sickness has been a persistent
phenomenon in the Indian economy since
the last two decades. In recent years, this has
assumed serious proportions because of
staggering amount of funds locked up in
sick units.
This article by Panigrahy and Mishra
discusses various approaches for predicting
the phenomenon of sickness in industries
and presents a multivariate cash flow model
to predict corporate sickness.
D Panigrahy is lecturer, Department of Business
Administration and D P Mishra is lecturer,
Department of Commerce, in the Business
School ofBerhampur University, Berhampur.
Vol.18, No.3, July-September 1993
money market and the capital market are reeling under
severe resource crunch, a substantial amount of funds
has been tied up in sick industries. The Economic Sur-
vey, 1991-92, reveals that as much as Rs 9353 crore of
bank credit had been locked up in 2,21,097 sick units by
the end of December 1990. Sickness of such a magnitude
causes loss of employment in these industrial units
which further aggravates the acute unemployment
problem prevailing in the country. Against this back-
drop, it is essential to develop a forewarning system, so
that timely remedial measures can be undertaken to
combat the menace of sickness.
Corporate Sickness and Cash Flow
In view of the growing number of sick industrial units
and mounting bank credit against them, various institu-
tions/agencies have been trying to identify and diag-
nose corporate sickness. The RBI, for instance, identifies
a sick unit as one which has incurred cash loss for one
year and, in the judgement of the bank, is likely to incur
further losses for the current year as well as for the
following year. Also, it has an imbalance in its financial
structure such as current ratio of less than 1:1 and
worsening debt-equity ratio (RBI Report, 1977-78). Ac-
cording to the Sick Industrial Companies (Special
Provisions) Act, 1985, which provided a new approach
to identifying sick companies, a sick industrial com-
pany can be defined as one (being registered for at least
seven years) which has at the end of any financial year
accumulated cash losses equal to or exceeding its entire
net worth and has also suffered losses in the current as
well as the immediately preceding financial year (Agar-
wal, 1989).
These definitions interestingly highlight one com-
mon issue, namely, the sustenance of cash loss and
erosion of net worth.. However, in India, sick companies
continue to exist and operate even after eroding their
total net worth because of availability of cash in the
form of loans, grants and subsidies. Most of the sick
industries lack the cash flow forecasting system and pay
little attention to cash flow information, which is per-
23
tinent to the survival and growth of business. Failure to
foresee the future inflow and outflow of cash jettisons
the sick units in a vicious circle.
In the current business situation, cash, like any
other asset of the company, is a tool for generating profit
and the emphasis is on the right amount of cash at the
right time, at the right place and at the right cost (Reed,
1963). The importance of cash flow is captured in the
statement: "if I had to make a forced choice between
having earnings information and having cash flow in-
formation today, I would take cash flow information"
(Horngren and Sundem, 1990). Even the Financial Ac-
counting Standards Board (FASB), US, contends that
"the greater the amount of future net cash inflows from
operations, the greater the ability of the enterprise to
withstand adverse changes in operating conditions"
(Casey and Bartczak, 1984). The flow of cash into and
out of the business can thus be regarded as the barome-
ter of corporate health. Keeping this in view, it has been
decided to take cash flow as the prime variable in this
study for predicting corporate sickness.
Corporate Sickness and Predictive Models
Many researchers have undertaken empirical studies
on corporate failure/bankruptcy to predict the event of
business failure before its actual occurrence. Notable
among them are Altman (1968), Deakin (1972), Blum
(1974), Libby (1975) and Taffler and Tisshaw (1977).
They have used different sets of financial ratios as
predictor variables to study corporate health with the
help of either one of the sophisticated statistical tools
such as factor analysis or multiple discriminant analysis
or both. Most of these studies focus on the use of several
combinations of varieties of financial ratios. However,
none of these studies has dealt with cash flow and its
related ratios as potential predictor variables. More
recently, however, researchers have carried out studies
on corporate failure using the cash flow information.
Gale and Branch (1981) have made a study using the
Profit Impact of Market Strategy (PIMS) business data
for the period 1970-79 assembled by the Strategic Plan-
ning Institute. Their empirical study demonstrated that
a business's competitive position, the growth rate of its
market and its current strategic moves had a predictable
effect on the cash flow. This helps the business firm to
evaluate the trade-off among alternative strategies to
use the cash.
In their study, Casey and Bartczak (1984) selected
60 companies that had filed petitions for bankruptcy
14
during the period 1971-82 and matched them with 230
viable companies chosen at random from similar in-
dustry groupings. They had considered three variables,
namely, operating cash flow, operating cash flow
divided by current liabilities and operating cash flow
divided by total liabilities. Using the multiple dis-
criminant analysis, they found that cash flow measures
proved to be poor predictors when compared to six
accrual based financial ratios used in the model. Even
the cash flow measures taken together with the accrual
based ratios failed to improve the predictive accuracy.
The predictive accuracy of cash flow based measures
was found to be 60 per cent for operating cash flow, 75
per cent for operating cash flow/current liabilities and
72 per cent for operating cash flow/total liabilities one
year prior to failure, whereas the accrual based financial
ratios provided 86 per cent classification accuracy one
year prior to failure. They, therefore, concluded that
cash flow based measures are poor indicators of cor-
porate bankruptcy as compared to accrual based finan-
cial ratios.
Gentry, Newbold and Whitford (1985) have il-
lustrated how the trends of funds flow components aid
in determining financial health or weakness of a com-
pany. Analysing a matched sample of 33 each of failed
and non-failed companies in a particular industry, they
found that the mean and the deviation of each cash flow
ratio for the failed and the non-failed firms are different
from each other. Their study indicates a marked dif-
ference between the means of the bankrupt companies
and the financially healthy companies. The study also
used probit model taking 12 funds flow components to
predict the probability of failure. The predictive model
classified the failed companies from the non-failed ones
at 83.3 per cent accuracy one year prior to failure. The
study clearly showed that dividends are more impor-
tant in distinguishing between failed and non-failed
companies. The predictive value of net cash flow,
receivables and investments changes dramatically as a
company approaches failure.
In the Indian context too, prediction of corporate
sickness has been made by a few researchers. Kaveri
(1980), for instance, had conducted a study on sickness
prediction in small scale industries using multiple dis-
criminant analysis. This study provided 76 per cent
classification accuracy one year in advance of sickness.
Bhattacharaya (1982) attempted to develop a model
using multiple discriminant analysis in order to identify
the different symptoms which explain the sickness
phenomena and to analyse their relative contribution in
Vikalpa
determining the propensity of sickness. This model,
applied to a sample of 28 sick and 26 healthy companies,
correctly classified the companies with 80 per cent ac-
curacy. Gupta (1983) had carried out a study to deter-
mine the important ratios for monitoring corporate
sickness. His study concluded that profitability ratios
had relatively more predictive power and the com-
panies having low or inadequate equity base (reserve
strength) were more prone to sickness. While these
studies have employed different financial ratios for
determining corporate sickness, there has been no
study exclusively devoted to cash flow variables as
indicators of corporate health. In order to understand
the potentialities of cash flow variables, this study ex-
clusively considers cash flow information for predict-
ing the corporate health status.
Research Design and Methodology
This study aims at designing a cash flow variable model
to predict corporate sickness. In order to develop the
model, a sample of 45 sick and 45 non-sick companies
was selected. The sample of sick companies in which
sickness was reported between the period 1977-87 was
drawn at random from 12 different industry groups.
The primary list of sick companies was prepared from
the Bombay Stock Exchange Official Directory. Data on
these companies could be obtained for at least five years
prior to the occurrence of sickness. Broadly, the com-
panies to be included in the list were identified based
on the definition given by the Sick Industrial Com-
panies (Special Provisions) Act, 1985. In addition, com-
panies which had not paid dividend for several years
and with low market value of shares were also included
in the sample. This list of 45 sick companies thus
prepared was matched with non-sick companies on the
basis of size, age, nature of industry and fiscal year of
comparison. The average capital employed by sick and
non-sick companies was Rs 509 lakh and Rs 539 lakh
respectively. (The sample list of sick and non-sick com-
panies is available with the authors on request.)
From the financial statements, the cash flow and the
ratios (numbering 16) related to cash flow were calcu-
lated. The cash flow ratios were grouped under two
heads:
• Traditional Cash Flow (TCP) ratios
• Operating Cash Flow (OCF) ratios.
The TCP represents the earnings before deprecia-
tion and taxes (EBDT) and the OCF represents earnings
Vol.18, No.3, July-September 1993
before depreciation and taxes plus or minus changes in
the current operating accounts. This classification has
been made to represent different aspects of the opera-
tions of the company. The selection of cash flow ratios
has been made keeping in view their popularity in
literature, the performance of such ratios in earlier
studies and their relevance for the present study. Ap-
pendix 1 gives the explanation of the ratios used in the
study.
The analysis and interpretations of this study have
been made through multivariate approach. The Multi-
ple Discriminant Analysis (MDA) has been applied as
an appropriate statistical technique under the multi-
variate analysis. Besides this, scaled vector technique
and multivariate F-test were also used.
Analysis and Results
In the multivariate analysis, a combination of cash flow
ratios is studied simultaneously to achieve a linear dis-
criminant function of such ratios in the form of
Y = λ1X1 + λ2X2 + λ3X3 ……..+ λnXn where λ1, λ2,
λ3....... λn are the discriminant coefficients and X1,X2
Xn are the independent variables (ratios). Putting
the actual values of the variables in the discriminant
equation, a score known as the Y-score is finally
obtained. Thus, the multiple discriminant analysis
calculates the discriminant coefficients λj , whereas
the independent variables Xj are the given actual values
and j=l,2...n. To determine the weighting coefficients
λ1, λ2, λ3 …….λn, the inverse of within-the-groups
variance-covariance matrix is multiplied by the vector
of mean differences, which is represented in a matrix
notation λ = c-1d. Here c-1 is the inverse of within-
the-groups variance-covariance matrix, d is the vector
of the mean difference and λ represents the weighting
coefficients defining the best discriminating linear
combination of the original Xn scores. Before designing
the MDA model, the statistical tests like t-test and F-
test (analysis of variance) were carried out to screen
out the insignificant ratio variables. Based on the t
and F values (Table I)*, altogether 14 cash flow ratios,
seven each from TCP and OCF groups, were found
statistically significant. The seven variables of both the
groups Were analysed using the programme on MDA**
developed by Mather (1976). After several computer
runs, the coefficients of both TCP and OCF ratios
were determined. The eight vari-
* Tables are at the end of the article.
** MDA Programme was run using the Fortran language in PSI
Sirius - 32 Mini Computer (UNIX Operating System).
15
able profile of TCP and OCF ratios was also introduced variate analysis. The TCP-based discriminant model
to the computer programme to find out whether there has proved its superiority over the OCF-based dis-
was any improvement in the classification accuracy of criminant model in segregating sick companies from
the model with the inclusion of one more variable in the non-sick companies with a high percentage of accuracy.
discriminant model. The discriminant function of both Hence, it can be concluded that cash flow ratios have a
the TCP and OCF ratio groups for seven and eight higher rate of accuracy in predicting as well as signall-
variable models is presented in Table 2. When multi- ing corporate sickness in advance.
variate F-test was applied to each of the MDA models,
the OCF model was rejected because it was not statisti- The cash flow forecasting model presented here can
cally significant. In the TCP ratio group, even though be relied on to a great extent for predicting the financial
the seven and eight variable models were found sig- health of companies. Potential investors and financing
nificant, only the model consisting of seven variables agencies like banks and financial institutions may use
was selected because it had a higher multivariate F- the model for knowing the health of a unit at the time
value. Thus, the derived seven variable discriminant of investment. The management of sick companies may
model takes the form: also find this model useful in order to take suitable
measures to improve the indicators discussed in the
Y = 4.99X1 - 13.97X2 - 1.87X3 - 0.12X4 + 0.76Xs + 2.28X6 - model and start the process of revitalization. This, in
1.24X8 turn, would lead to considerable savings of scarce
resources in our economy.
When the scaled vector technique was applied to
the above model, the TCF/TL variable did show the Table 1: T & F Values of Ratios for the Two Groups
highest discriminating value (Table 3). The importance One Year Prior to Sickness
of each variable is stated and explained in Appendix 1.
The Y-score values of both sick and non-sick companies
in the first year prior to sickness are calculated and
presented in Table 4. The cut-off point for Y-score
values was determined at -0.4221. It represents the mid-
values of the summation of the mean Y-score values of
sick and non-sick companies. Given this cut-off point,
the companies are classified as sick if their Y-scores are
above this cut-off point and non-sick if their Y-scores
are below this cut-off point. Based on this cut- off point,
the classification accuracy of the model one year prior
to sickness is estimated at 86.67 per cent. The type I and
type II errors* are both found to be 13.33 per cent. The
details of the classification accuracy and the error rates
up to five years prior to sickness are computed and
presented in Table 5. It can be observed from the table
that the discriminant model retains the classification
accuracy of 78.89 per cent up to the third year prior to
sickness. However, the classification accuracy rate falls
in the fourth and the fifth year prior to sickness because
of the increase in the lead time and the indicators (cash
flow ratios) becoming passive and less clear.

Findings and Conclusions

The findings of the study indicate that cash flow ratios
are good indicators of corporate health under multi-

Type I error would predict a sick company not to fail and type
II error would predict a non-sick company to fail.

16 Vikalpa
 Table 2: Discriminant Functions of TCF and OCF Table 4: Discriminant Score One Year
Variables One Year Prior to Sickness Prior to Sickness

Sl. Discriminant Cut-Off Multi- Sick Y·Value Non-Sick ¥-Value

No. Function Point variate Companies Companies
F-Value
101 2.9880 201 -2.3568
1 Y:::5.0179Xt-14.2530Xz-1.8518X3 102 1.1434 202 -3.4420
~.1252X4+0.7732Xs+2.3514X6 103 3.6164 203 -o.7t58
+0.0021 X?-1.2415Xs -0.4255 4.1238 104 4.2666 204 -5.7153
2 Y::3.7800X9-6.7385Xt~2.1463Xtt 105 3.6581 205 -1.2942
-Q.1218Xt2+1.1372XtMJ.4984Xt4 106 1.1109 206 -2.7851
-o.0021Xts-o.0564Xt6 -o.2394 0.7(175•
107 1.2493 207 0.7969..
3 Y=4.9965Xt-13.9754Xz-1.8701X3 -0.058}'0
108 3.7286 208
-0.1254)4+0.7621Xs+2.2826X6
109 0.7157 209 -1.8732
-1.2477Xs -o.4221 4.7773
110 2.8176 210 -2.6922
4 Y::3.3831X~.4763Xt~2.1588Xtt
-o.t222Xt2+1.1705XtMJ.4946Xt4 111 1.6038 211 -o.5562
-o.0512Xt6 -0.2279 0.8277» 112 -1.7162• 212 -5.5450
113 -0.7389• 213 -4.7896
• denotes insignificance at 0.05 level. 114 1.6648 214 -4.4529
115 6.1542 215 -2.5697
116 1.1334 216 -1.8004
Table 3: Scaled Vectors Indicating Relative 117 0.3979 217 -5.9838
118 0.0%4 218 -3.2363
Contribution of the Variables (Ratios)
119 -0.2756 219 -1.5071
120 3.2758 220 -2.1645
Variable Smled Vector Ronking
121 1.9841 221 -2.4412
TCF/TA 0.5924 4 122 5.2614 222 :-1.4644
Xt
-1.9864 1 123 -o.s1ss• 223 -1.8688
X2 TCF/Tl
XJ TCF/NS -o.3557 6 124 -o.6949't 224 -1.3851
X. TCF/NW -o.4336 5 125 6.3328 225 -3.9673
Xs TCF/CA 0.2779 7 126 1.3254 226 -3.8868
X6 TCF/Cl 0.6181 3 .127 -0.3790 227 -o.3311..
128 2.2181 228 -3.7209
Xs TCF/TC -1.2569 2
129 -0.1304 229 -1.1348
Legend: TA: Total Assets Tl Total liabilities 130 -0.6636• 230 -1.7462
NS: Net Sales NW: Net Worth 131 1.3279 231 0.841~
CA: Current Assets Cl Current liabilities 132 0.2615 232 -o.3462.
INT: Interest TC: Total Capital 133 0.2086 233 -9.6732
134 -o.1922 234 -2.3427
135 5.0169 235 -o.7276
136 1.8182 236 -Q.1459*
137 1.4585 237 -4.9390
138 0.3621 238 -2.3507
139 0.3208 239 -2.37(17
140 6.3063 240 -1.1959
141 -1.0102.. 241 -1.7296
142 1.1294 242 -1.0246
143 0.9704 243 -3.6192
144 0.9111 244 -2.9129
145 1.3488 245 -2.6326

• Denotes misdassified companies.

Vol.18, No.3, July-September 1993 17

 Table 5: Five Years Classification Accuracy of the
Discriminant Model
Year Number of Number Number Percentage
Prior to Companies Correctly Misclassi- of Correct
Sickness Classified fied Classification
Appendix 1: Ratios Used in the Study
Traditional Cash Flow to Total Assets (TCF/TA)
This ratio is a measure of the true productivity of the
company's assets. It is expressed as the earning before
depreciation and taxes divided by total assets. It indi-
cates how effectively assets are being employed in
generating cash. This is the real test of economic success
or failure of the firm, because the survival of the com-
pany depends directly on the earning power of its as-
sets. A smaller TCF/TA ratio of a company is believed
to provide indications of financial crisis in the future. A
higher TCF/TA ratio is indicative of stronger financial
health of a company as it implies that the company has
generated enough cash to pay off its obligations. Thus,
we can say that a direct relationship exists between this
ratio and the company's health.
Traditional Cash Flow to Total Liabilities (TCF/TL)
This ratio indicates the company's capacity to
withstand financial pressure and shows the long run
liquidity position of the firm. It is expressed as earnings
before depreciation and taxes divided by total
liabilities. As expected, the greater the cash flow to total
liabilities, the more likely the firm would be classified
as a non- failing firm. The TCF/TL ratio relates resource
inflow to total claims, thereby showing the long run
liquidity of the company. Since a firm's ultimate exist-
ence is based on its credit availing or fund raising
capacity (both from outsiders and shareholders), this
ratio gives sufficient indication to the investors whether
to extend or restrict credit to the company. This ratio,
therefore, appears to be particularly relevant for studies
dealing with corporate failure. Further, insolvency in a
failing sense occurs when the total liabilities outweigh
the cash generating power of the company. A smaller
TCF/TL ratio provides insight into the impending sick-
18
ness of the company and a higher ratio reflects the
company's strength to meet its obligations.
Traditional Cash Flow to Net Sales (TCF/NS)
This ratio shows the operating efficiency of the com-
pany in generating cash from business. It is expressed
as earnings before depreciation and taxes divided by
net sales. As known, the greater the cash flow to net
sales, the lesser the amount of sales unrealized, the
lower the cost of sales and vice-versa. Thus, TCF/NS
ratio relates the resource inflow to the amount of sales
of the company, since the basic aim of business is to
generate cash through sales. This ratio also reveals
whether the company would be able to survive on its
own or not thereby indicating its internal cash genera-
tion ability. Another important aspect of this ratio is that
it analyses the operational liquidity of the company.
The cash generated per rupee of sales is a reliable in-
dicator of the ability of the business enterprise to
generate enough cash for its operational requirements.
Traditional Cash Flow to Net Worth (TCF/NW)
Many analysts believe that the greater the cash flow to
net worth ratio, the better the financial structure of the
company. But extensive reliance on net worth (owner's
equity) can be expensive and may mean loss of potential
business opportunities. On the other hand, undue
reliance on outside borrowings can lead to liquidity
problems (the consequence of which can be very severe
in the context of commitments for repayment) par-
ticularly when the cash generation capacity of the
enterprise is low. Therefore, this ratio must not be
looked at in isolation in order to evaluate whether the
company has utilized the owner's fund efficiently or
not. The objective of studying this ratio is to examine
the financial solvency of a company in terms of its
ability to avoid financial risk.
Traditional Cash Flow to Current Assets (TCF/CA)
.By analysing this ratio, considerable understanding and
insight can be obtained regarding a company's ability
to manage its working capital in the form of receivables,
inventories, payables as well as interrelated sales credit
and purchase credit policies. The important thing to
remember in this context is that while most current
liabilities are indeed current, this is not necessarily true
of all current assets, particularly inventories and receiv-
ables. So if any analysis is made without the idea of the
realizability of receivables and inventories, this ratio
Vikalpa
can give misleading results. This ratio becomes more
significant in the prediction of corporate health espe-
cially in a situation where a large portion of the current
assets of the company comprises of obsolete stocks or
when there are long-term outstanding debts due to
which the company may fail in spite of its strong li-
quidity position.
Traditional Cashflow to Current
Liabilities (TCF/CL)
The greater the cash flow to current liabilities, the more
likely the company would be classified as a non-failing
company. This ratio is an indicator of short-term sol-
vency of the company. This ratio shows liquidity in the
sense of the ability of a firm to meet current obligations
when they become due for payment. In fact, liquidity is
a prerequisite for the very survival of the firm. The
short-term creditors of the firm are interested in short-
term solvency or liquidity of a firm. Thus, this ratio is
best used to measure the short-term financial strength
of a firm and is widely accepted as the best available test
of the liquidity position of a firm.
Traditional Cash Flow to Total Capital (TCF/TC)
The term total capital refers to long-term funds sup-
plied by the creditors and owners of a firm. A com-
parison of this ratio with the industry average and over
time would provide sufficient insight on how effective-
ly the long-term funds of owners and creditors are
being used to generate cash for operational and other
purposes. This ratio has wider coverage and it examines
the ability of a firm to pay interest on loan as well as
repayment of capital along with payment of dividend.
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