The role of liquidity and solvency in the probability of DFI loan defaults by private firms

Abstract

The aim of this research was to investigate the role of liquidity and solvency in the prediction of DFI (ÒDevelopment finance institutionÓ) loan defaults held by private firms. The research further considered the contribution of firm size and industry group in the prediction of DFI loan defaults. The study made use of firm-level and industryÐlevel data maintained by the Industrial Development Corporation consisting of 566 accounts of privately-held firms for a period between 2008 and 2014. Through using a binary logistic regression technique, the empirical results showed that solvency is statistically significant in explaining DFI loan defaults such that when solvency improves, the likelihood of default reduces. The study further showed that, even though firms at default are illiquid, liquidity is not a significant variable in the prediction of DFI loan defaults. Firm size did not influence the role of solvency and liquidity in DFI loan defaults. However, Industry group was found to have a significant influence in the DFI loan default prediction models. The inclusion of solvency and industry group variables is expected to improve the predictive power of default prediction models on DFI loans. This research only focused on private firms default behaviour towards DFI loans which limits its generalizability to other population groups. The study contributes to the literature of corporate failure prediction and represents one of very few sets of results on the determinants of default in private firmsÕ DFI lending. This research can assist DFIs and managers in understanding the factors that impact the credit risk of privately held firms.