Use of Altman’s Z score and Merton Model by Banks to Predict Bankruptcy in Indian Corporates

Abstract

There has been a recent increase in the financial distress in assets of the banking industry. Constant defaults by corporate houses have led banks reach gross NPA levels of 5%.One major reason for this rise can be improper risk assessment by banks while giving out loans and improper monitoring of their portfolio companies. And further Indian banks do not use the most robust risk assessment tools and fail in taking early warning action. The paper tries to use two popular models, namely the Altman Zscore model and the Merton Model to predict financial distress in companies which have been the top defaulters in the recent past.The paper tried to determine whether such models are effective in predicting financial distress and how much before the occurrence of the actual event. Financial ratios and other quantitative data from March 2009- March 2013 forms the sample for the study for Kingfisher Airlines, MoserBaer, Gammon India, Educomp Solutions and Deccan Chronicles. The study found Merton model to be a better indicator of financial distress (of companies) than Altman Z score model. However, none of the models were able to judge the possibility of default at the time of issuance of loan indicating at its limitation. Nevertheless, these models which essentially are data driven for assessing the credit risk must widely be used by banks more often, replacing the existing reliance on simple ratios and intuition method.