Distance to Insolvency

Insolvency often precedes default for nonpayment of debt. A firm is instantaneously insolvent whenever the market value of its assets is below the face value of its debt. Default occurs when the firm is instantaneously insolvent when the firm's debt matures. The natural log of the ratio of the market value of assets to face value of debt measures distance to insolvency (or degree of insolvency) in the Black-Scholes formula and Merton distance to default. The measure is useful outside of the restrictive conditions of option pricing theory. It is negative for instantaneously insolvent firms, zero for firms at the border of solvency and insolvency, and positive for an instantaneously solvent firm.