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The Journal of Risk Finance

Predicting probability of default of Indian corporate bonds: logistic and Z-score model
Arindam Bandyopadhyay
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Arindam Bandyopadhyay, (2006),"Predicting probability of default of Indian corporate bonds: logistic and Z-
score model approaches", The Journal of Risk Finance, Vol. 7 Iss 3 pp. 255 - 272
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banks", International Journal of Islamic and Middle Eastern Finance and Management, Vol. 4 Iss 2 pp.
Fernando Castagnolo, Gustavo Ferro, (2014),"Models for predicting default: towards efficient forecasts",
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Logistics and
Predicting probability of default Z-score model
of Indian corporate bonds: logistic approaches
and Z-score model approaches
Arindam Bandyopadhyay
National Institute of Bank Management (NIBM), Kondhwe Khurd, Pune, India

Purpose – This paper aims at developing an early warning signal model for predicting corporate
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default in emerging market economy like India. At the same time, it also aims to present methods for
directly estimating corporate probability of default (PD) using financial as well as non-financial
Design/methodology/approach – Multiple Discriminate Analysis (MAD) is used for developing
Z-score models for predicting corporate bond default in India. Logistic regression model is employed to
directly estimate the probability of default.
Findings – The new Z-score model developed in this paper depicted not only a high classification
power on the estimated sample, but also exhibited a high predictive power in terms of its ability to
detect bad firms in the holdout sample. The model clearly outperforms the other two contesting models
comprising of Altman’s original and emerging market set of ratios respectively in the Indian context.
In the logit analysis, the empirical results reveal that inclusion of financial and non-financial
parameters would be useful in more accurately describing default risk.
Originality/value – Using the new Z-score model of this paper, banks, as well as investors in
emerging market like India can get early warning signals about the firm’s solvency status and might
reassess the magnitude of the default premium they require on low-grade securities. The default
probability estimate (PD) from the logistic analysis would help banks for estimation of credit risk
capital (CRC) and setting corporate pricing on a risk adjusted return basis.
Keywords India, Bonds, Modelling, Emerging markets
Paper type Research paper

Corporate liabilities have default risk. There is always a chance that a corporate
borrower will not meet its contractual obligations and may renege from paying the
principal and the interest due. Even for the typical high-grade borrower, this risk is
there even though it may be small, perhaps 1/10 of 1 percent per year. Although these
risks do not seem large, they are in fact highly significant. They can even increase
quickly and with little warning. Further, the margins in corporate lending are very
tight, and even small miscalculations of default risks can undermine the profitability of
lending. But most importantly, many lenders are themselves borrowers, with high
levels of leverage. Unexpected realizations of default risk have destabilized,
decapitalized, and destroyed many internationally active lending institutions.
Following the release of the recent Reserve Bank of India (RBI) draft guidelines
(February 15, 2005) for the implementation of Basel II norms, the leading Indian banks The Journal of Risk Finance
Vol. 7 No. 3, 2006
are preparing to design appropriate internal credit risk models. The major motive is the pp. 255-272
incentive based approach for capital estimation for credit risk. In order to fetch the q Emerald Group Publishing Limited
early rewards of Basel II implementation, banks have to develop their own internal DOI 10.1108/15265940610664942
JRF models for credit risk. Internal models offer an opportunity for a bank to measure and
7,3 price counter-party risk and systemize risks inherent in lending. Prediction of default
probability (PD) for each borrower or group of borrowers is the key input for the
estimation of regulatory capital as well as economic capital for banks. It is also equally
important for the banking industry and financial institutions to discriminate the good
borrowers (non-defaulting) from the bad borrowers (defaulting). This will not only help
256 them in taking lending decisions but also practicing better pricing strategies to cover
against the counter party risk. While, internationally, considerable research has been
made to predict corporate default, very few attempts have been done for Emerging
Market like India.
The purpose of this paper is to build a robust framework that enables banks and
financial institutions in emerging market economy like India to classify a firm in the
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default or non-default category based on the information of its financial variables. This
kind of model can serve as a useful tool for quick evaluation of the corporate risk
profile. Second, it can also be used to track the firms to check for their default status
over time. As a result such model can help banks to get an early warning signal about
the default status of its corporate clients. In this paper, we estimate an MDA model to
predict corporate default using a balanced panel data of 104 Indian corporations for the
period of 1998 to 2003. The financial ratios and other basic information are collected
from the Centre for Monitoring Indian Economy (CMIE) Prowess database. This
database is similar to the Compustat database in the USA. However, as we have
mentioned earlier, it is not enough to know a qualitative differentiation of
counter-parties for properly evaluating credit risk. One has to go one step further
and differentiate quantitatively between different counter-parties. Accordingly, we
also estimate probability of default (PD) of each firm for the same corporate portfolio
through logistic regression. Here we also explore the role of non-financial factors in
predicting default. For this purpose, we empirically examine whether the combined use
of financial and non-financial factors lead to more accurate PD estimates.
The rest of the paper is structured as follows. In the next section we discuss about
the data, definitions and construction of variables and hypotheses. The third section
portrays the corporate bond default rates across different rating grades in India as well
as industry wise default rates. In the fourth section, we demonstrate the development
of the Z-score model for Indian corporations, main results, and the model validation.
The fifth section presents the results and methodology of logistic analysis to predict
corporate bond defaults. Here we also compare the significance of financial and
non-financial parameters in describing default risk. We have also tested the predictive
power of logistic model. The sixth section discusses the main conclusions.

Literature survey
In theory, corporate insolvency is indicated either by fall in the asset value or due to
liquidity shortage (i.e. falls in the ability to raise capital to finance project). Therefore,
we should expect that the ratios that reflect the cash flow structure and movement of
market value of firm’s asset to be different among defaulted and solvent firms (Wilcox,
1971; Scott, 1981). Several later studies incorporated these theoretically determined
financial characteristics in the explanation of corporate default. For example, Casey
and Bartczak (1985), Gentry et al. (1985) and Aziz et al. (1988) used cash flow variables
in their model in predicting corporate failure. Opler and Titman (1994) and Asquith
et al. (1994) report that default is primarily caused by firm-specific idiosyncratic Logistics and
factors. On the other hand, researchers like Lang and Stulz (1992) and Denis and Denis Z-score model
(1994) argue for a systematic nature of bankruptcy risk. Kranhnen and Weber (2001)
presented a normative set of generally accepted rating principles that point out the approaches
necessity of links among industry risk, business risk, financial risk, management risk,
facility risk, and probability of default. Grunert et al. (2005) analyzed credit file data
from four major German banks and found empirical evidence that the combined use of 257
financial and non-financial factors leads to a more accurate prediction of future default
events than the single use of each of these factors. Other studies look at the relation
between default and the stock market. KMV Corporation of Moody (1993) using Black
and Scholes (1973) approach made an attempt to predict default in an option pricing
context; i.e. to model when the option to default has more value than the option to
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Because of the lack of a unifying theory, there has been an explosion of different
empirical methods used to predict business failure in different markets. Statistical
models can help banks to predict default probability to get an early warning signal
about the default status of the corporate clients. Excellent reviews of the plethora of
studies can be found in Dimitras et al. (1996) and Mossman et al. (1998). The first
approach to predicting corporate failure has been to apply a statistical classification
technique called MDA to a sample containing both failed and non-failed firms. Studies
like Beaver (1966) and Altman (1968) pioneered this approach. Beaver (1966, 1968) did
univariate analysis of a number of bankruptcy predictors and set the stage for
multivariate attempts by him and others. He found that a number of indicators could
discriminate between matched samples of failed and non-failed firms for as long as five
years prior to failure. He also developed a Z-score model by using multivariate analysis
in 1968. In the same year, Altman developed his classic multivariate insolvency
prediction model (MDA) for publicly traded manufacturing firms in the USA. The
initial sample in his study is composed of 66 corporations with 33 firms in each of the
two groups distressed and solvent. The indicator variable Z-score forecasts the
probability of a firm entering bankruptcy within a two-year period (the cut-off score is
below 1.81). In the original Z-score formula for predicting bankruptcy Altman (1968)
employed working capital/total assets ratio, retained earnings/total assets ratio,
earning before interest and taxes/total assets ratio, market value of equity/book value
of total debt ratio, and sales/total assets ratio as predictor of financial health of a
In Altman et al. (1977) constructed a second-generation model with several
enhancements to the original Z-score approach. The new model, which was called
ZETA, was effective in classifying bankrupt companies up to five years prior to failure
on a sample of corporations consisting of manufacturers and retailers. The ZETA
model tests included non-linear (e.g., quadratic) as well as linear discriminate models.
The non-linear model was more accurate in the original test sample results but less
accurate and reliable in holdout or out-of-sample forecasting. Subsequently, in Altman
et al. (1995) modified his Z-score model to emerging market corporations, especially
Mexican firms that had issued Eurobonds denominated in US dollars. In this enhanced
Z-score model, he dropped sales/total assets and used book value of equity for the
fourth and final variable to make it more suitable for the private firms.
JRF Several researchers influenced by the work of Altman (1968) on the application of
7,3 discriminant analysis, explored ways to develop more reliable financial distress
prediction models. Subsequently, new analytical techniques like logit or probit models
(Martin, 1977; Ohlson, 1980; Zavgren, 1985; Lennox, 1999; Westgaard and Wijst, 2001;
Grunert et al., 2005), multidimensional scaling (Mar Molinero and Ezzamel, 1991),
artificial neural networks (Tam, 1991; Wilson and Sharda, 1994/1995), multinomial
258 logit (Johnsen and Melicher, 1994), multicriteria decision aid methodology (Zopounidis
and Dimitras, 1998), etc. have been introduced to predict corporate failure in different
As one can see from the collective literature discussed above, a very large number of
empirical bankruptcy prediction models do multiple discriminant analysis (MDA)
pioneered by the seminal works of Altman (1968, 1995) based on the accounting data.
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However, these models, though worked successfully, are very much country specific
and may not fit well with the Indian condition. The ratios as well as the weights of
MDA would differ across countries and regions (as one can see the Altman’s original
1968 model for US manufacturing firms is different from that of Emerging Market
model of 1995 based on Mexican data). Further, Z-score model only gives prediction
about the qualitative differentiation of counterparties. If banks are interested to
directly estimate the probability of default (PD), MDA analysis is not applicable since it
does not produce such probabilities.
One possible solution for banks, which intends to estimate PD directly, is the use of
limited dependent logit model (similar to Amemiya, 1981; Maddala, 1983). Unlike the
discriminant model, the logistic model has the flexibility to incorporate both the
financial as well as non-financial factors in predicting default. While the financial
ratios capture the firm specific information, the non-financial factors help to evaluate
the link of the firm with macroeconomic factors and the capability of the firm to churn
out cash flow in the required numbers.

Sample data characteristics, variable definitions, and hypotheses

The information on defaulted and solvent firms is collected from CRISIL’s annual
ratings of long-term bonds issued by 542 companies from 1998 until 2004. These
companies are then matched by their asset size, year, and industry affiliation.
Following these criteria in a random selection, we finally got a sample of 52 solvent
firms and 52 defaulted firms. The defaulted group is a class of manufacturers whose
long-term bonds have been defaulted between 1998 and 2003[1]. The solvent firms are
chosen on a stratified random basis drawn from CRISIL rating database. The mean
asset size of the firms in the solvent group (Rs. 948.51 Crore) is slightly greater than
that of the defaulted group (Rs. 818.62 Crore), but matching exact asset size of the two
groups is not always necessary[2]. The financial information of these 104 companies
over the period of 1998 to 2003 is obtained from the CMIE Prowess database. In
addition to the accounting data, information on ISO certification is obtained from the
Q-Prod’s directory. In order to test the predictive accuracy of our estimated sample, a
holdout sample of another 50 (25 solvent and 25 defaulted) companies is being created
for the years 2003 and 2004. Our estimated sample of 104 firms have been classified
into 11 industry categories based on their major economic activities after matching
them with the National Industrial Classification (NIC) codes (see Table I).
Logistics and
Industry dummy Industry type Number of firms
Z-score model
IND1 Food products/sugar/tea/tobacco/beverages 4 approaches
IND2 Paper 3
IND3 Textile 9
IND4 Chemical 27
IND5 Machine/electrical/computers 14 259
IND6 Metal/non-metal 23
IND7 Auto/parts 6
IND8 Power 2
IND9 Diversified 5
IND10 Service 9 Table I.
IND11 Other manufacturing 2 Industry categories of
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Total 104 sample companies

As we discussed in the introductory section, the variables to be included in bankruptcy

prediction models should be able to relate the properties of the cash flow in
combination with the debt obligations and the movement in the asset value of the firm.
While MDA technique can successfully draw the best combination of key ratios from a
large set of financial ratios, the logistic model can capture more firm specific
idiosyncratic factors and also can relate the firm to the macro economic conditions. We
initially started with many financial ratios and finally arrive at five key ratios (in our
MDA model) that best discriminate between our sample of good and bad firms. In
order to pick up the best ratios, we looked at:
F and Wilk’s Lambda statistics to check the statistical significance of each
individual ratio, including determination of relative magnitude of each
independent variable (i.e. standardized values of their coefficients).
Within sample discriminatory power of these ratios’ best combinations.
Chi-square statistic as check for the overall significance of various discriminant
functions and finally.
Our own analytical judgment.

The final profile of ratios is as follows:

WK_TA: working capital over total assets is a measure of the net liquid assets of
the firm relative to the total capitalization. Working capital is defined as the
difference between current assets and current liabilities. Hence the ratio is a
proxy for the short-term liquidity condition of the firm.
CASHPROF_TA: cash profit over total assets is a measure of cash flow of the
firm. Cash profit is obtained by adding the non-cash charges such as depreciation
and amortization to the profit after tax (or net profit).
. SOLVR: solvency ratio judges the long-term solvency of a firm. Higher the
solvency ratio better is the ability of the firm to meet key term obligations and
lower will be the probability of default. The solvency ratio is computed by
dividing the firm’s total assets (net of revaluation reserves, advance tax and
miscellaneous expenses not written off) by its total borrowings plus current
liabilities and provisions minus advance payment of tax.
OPPROF_TA: operating profit over total assets is a measure of the true
7,3 productivity of the firm’s assets. It measures the firm’s earning capability. The
higher is the ratio, the better for the company.
SALES_TA: the capital turnover ratio is a standard financial ratio (also used by
Altman in his original 1968 model) illustrating the sales generating ability of the
firm’s assets. It is the ratio of total sales to total assets. This ratio gives an
260 indication as to how efficiently a company is utilizing its assets. Higher is this
ratio, the better for the company.

In the logit analysis, we have included another financial variable: MVE_BVL – the
equity market value over the book value of the liabilities proxy for the firm’s asset
values. It also measures the solidity of the firm. In calculating book value of total
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liabilities, total net worth of the firm is subtracted from the total liability of the firm.
Hence, the BVL gives the book value of total outside liabilities of the firm.
All the six ratios represent either value or income of the firms with respect to total
assets. They are all hypothesized to be either positively related to solvency or
negatively related to the firm’s default probabilities.
Following non-financial variables are taken from the existing literature about
corporate solvency:
Age of the firm. Age of the company since incorporation. A relatively young firm
will probably show a low retained earnings/total assets (RE/TA) ratio because it
has not had time to build up its cumulative profits (Altman, 2000). Therefore, it
may be argued that the young firm is somewhat discriminated against in this
analysis, and its chance of being classified as bankrupt is relatively higher than
that of another older firm, ceteris paribus. But, this is precisely the situation in
the real world. The incidence of failure is much higher in a firm’s earlier years
[40-50 percent of all firms that fail do so in the first five years of their existence
(Dun and Bradstreet, annual statistics)]. The age effect is thus clear: young firms
are more likely to default. We take natural log of the number of years of the firm
since incorporation as measure of firm age.
Group ownership. Studies covering various countries have found that firms
associated with top business groups have greater stability in the cash flows and
show better productivity as well as risk sharing than unaffiliated firms
(Gangopadhyay et al., 2001). Together with the existence of mutual debt
guarantees through group affiliation, firms may reduce the possibility of
financial distress. Some studies delineating the effect of Indian business group
affiliation on firm sales have observed that top 50 business group firms have a
better reputation advantage in the product market and are likely to export more.
They are also on average spend more advertising, marketing, distribution and
research and development (R&D), and thus have larger amount of intangible
assets (Bandyopadhyay and Das, 2005). Accordingly, we can hypothesize that
top 50 business group firms are safer firms than their non-top 50 group
ISO Quality Certification (ISOD). This dummy is taken as a product market
signal about the firm that it maintains a quality management system and is
concerned with customer expectations and satisfactions. It has been empirically
observed that ISO certified firms are successful in the product market Logistics and
(Bandyopadhyay and Das, 2005). Therefore we assume that possessing an ISO Z-score model
certificate by a firm would reduce its chance of default.
Control variables-industry characteristics. The industry factors affect the firms’
performance and therefore affect default as well. There are incidents of clustered
incidents of default. In order to capture the industry specific effects, our sample
firms have been classified into 11 industry dummies depending on its major 261
economic activity.

Bond default rates in India

Table II presents an average one-year transition matrix of 542 corporate bond ratings
from 1995-1996 to 2004-2005. The transition probabilities captured in the matrix
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quantify the likelihood that a company will change from one rating grade to another
within a year. The one-year average stressed probability of default (PD) of various
rating notches are reported in the last column[3]. One can see that as the credit quality
worsens (i.e. decline in the rating grades), the probability of default increases. Further,
the PD jumps sharply as soon as we move from Investment Grade Bonds to
Non-Investment Bond Grades (say from 5.17 percent for BBB to 28.93 percent for BB).
We also observe that rating stability declines as the credit quality worsens. The higher
risk in the bottom grades (mainly non-investment grades) calls for developing a
corporate default predictor model that would better capture the firm’s characteristics
and could give an early warning signal of corporate distress. In Table III, we get an
idea about corporate bond default rates by major industry groups. As expected, the
default rate varies across different industries especially in the non-investment
category. The high default rates are found in Chemical, Food Products and Tobacco
and Beverages, Machine and Electrical, Metal and Non-Metal sectors, and Paper and
Textile sectors.

Development of the Z-score model for Indian corporations

Given the sample of 104 equal mutually exclusive classes of solvent and defaulted
firms over the period of 1998 to 2003, we estimate the multivariate linear discriminant
function to obtain a Z-score that will help to predict bankruptcy for new firms. The
solvent set of firms is matched with the defaulted set by asset size, industry, and year
of data. Several combinations of the variables were tried in order to estimate the best

Year 2
Year 1 AAA (%) AA (%) A (%) BBB (%) BB (%) B (%) C (%) D (%)

AAA 97.08 2.92 0.00 0.00 0.00 0.00 0.00 0.00

AA 2.54 87.57 7.93 1.05 0.60 0.15 0.00 0.15
A 0.00 4.35 79.97 9.14 3.48 0.44 0.73 1.89
BBB 0.00 0.74 5.90 67.53 14.76 2.21 3.69 5.17
BB 0.00 0.83 0.00 1.65 57.02 4.13 7.44 28.93 Table II.
B 0.00 0.00 0.00 7.41 0.00 55.56 7.41 29.63 Average one year
C 0.00 0.00 0.00 2.33 0.00 0.00 51.16 46.51 transition matrix (years
D 0.00 0.00 0.31 0.31 0.92 0.00 0.00 98.46 1995-1996 to 2004-2005)
Figures in percent
7,3 Industry IG NIG ALL

Auto/parts 1.79 16.67 2.87

Chemical 0.88 32.00 3.98
Diverse 3.70 18.75 7.14
262 Food products/sugar/tea/tobacco/beverages 1.37 55.56 7.41
Machine/electrical/computers 2.75 37.14 7.51
Metal/non-metal 3.11 35.48 6.60
Table III. Other manufacturing 0.00 0.00 0.00
Industry wide average Paper 0.00 33.33 5.66
PD for IG and NIG and Power 0.00 0.00 0.00
pooled, 1995-1996: Service 0.22 27.78 1.25
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2004-2005 Textile 1.52 40.00 5.44

distress classification function in a stepwise regression method. The essential

assumption is that variance-covariance matrices of the two groups are statistically
identical[4]. The weights of the discriminant function are the difference of the mean
vectors of the explanatory variables for the solvent and defaulted groups. In the MDA
model our purpose is two folds: The first one is to look for predictors (financial ratios)
that lead to lowest misclassification rates within the sample and the second one is to
get improved prediction accuracy in an un-estimated holdout sample.
The discriminant analysis model involves linear combinations of the following

Z ¼ b0 þ b1 X 1 þ b2 X 2 þ b3 X 3 þ . . . þ bk X k
where D ¼ discriminant score, bs ¼ discriminant coefficients or weights, and X s ¼
predictors or independent variables. The coefficients, or weights (b), are estimated so
that groups differ as much as possible on the values of the discriminant function. This
occurs when the ratio of between-group sum of squares to within-group of sum of
squares for the discriminant scores is at a maximum. Any other linear combination of
the predictors will result in a smaller ratio. The test statistics used for carrying out this
analysis is F and Wilk’s Lambda. Intuitively, a small Lambda signifies that a small
proportion of the total variance of the constituent variables is being accounted for by
within groups’ dispersions while a larger proportion of the total variance is explained
by the squared deviation of the between group means from their pooled mean. This
would be translating to a high value of the F-statistic, which means a greater chance
for the null of equal means to be rejected.

Results of the discriminant analysis

Based on the above methodology, three reduced form single equation of the original
discriminant equations and their summary results are reported in Table IV. Model 1 is
the rework of Altman’s original 1968 Z-score model. It comprises of variables that have
been used by Altman for analyzing corporate default chance in US market. The
coefficients of the variables have been re-estimated using the above data. Model 2
comprises of a set of four variables and is the revised form of Altman’s Emerging
Logistics and
Percent of correct
classification Z-score model
(within sample) approaches
Model Linear discriminant equation Good Bad

Model 1: re-worked Altman Z ¼ 2 1.689 þ 2.436WK_TA þ 84 82

(1968) 8.158RE_ TA þ 3.73PBIT_TA 263
þ 0.037MVE_BVL þ 1.602
Model 2: re-worked Z ¼ 2 1.096 þ 2.893WK_TA þ 88.2 75.9
emerging market (1995) 1.197RE_TA þ 11.711PBIT _TA
þ 0.042MVE_BVL
Model 3: new Z-score model Z ¼ 2 3.337 þ 0.736WK_TA 85.2 91
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þ 6.95CASHPROF _TA Table IV.

þ 0.864SOLVR þ Three alternative
7.554OPPROF_TA þ discriminant models for
1.544SALES_TA Indian firms

Market Score Model (1995). Model 3 of Table V is ours. This new Z-score model
comprises of five ratios. Two of these ratios are same to those in Model 1 namely
working capital to total assets (WK_TA) and sales over total assets (SALES_TA).
Three new variables are cash profits to total assets (CASHPROF_TA), solvency ratio
(SOLVR), and operating profit over total assets (OPPROF_TA). The discussion on the
expected signs of these ratios has already been done in variable definitions section.
Although Model 1 and Model 2 exhibit a reasonable high degree of classification
power, Model 3 (which is ours) has the best ability to classify the current sample of
good and bad firms. However, the robustness of Model 3 needs to be established by a
set of diagnostic tests.
The first set of tests pertains to checking the difference of the means of the two
groups, both individually and also as a whole for the entire function. From Table VI,
the magnitude of the Wilk’s Lamda and F-statistic of the individual variables (used in
Model 3) suggests that given the data, the likelihood of the means of the solvent and
defaulted groups to be equal is highly unlikely. Hence, the null hypothesis of the
equality of means with respect the same variance co-variance matrix for both the

Solvent Defaulted
(DEF ¼ 0) (DEF ¼ 1) Wilk’s Lambda for F-stat. for difference
Mean Std dev. Mean Std dev. difference in mean in mean

WK_TA 0.192 0.145 20.068 0.33 0.796 153.3 *

CASHPROF_TA 0.099 0.073 20.027 0.092 0.633 347.33 *
SOLVR 2.32 1.304 1.27 0.37 0.763 185.26 *
OPPROF_TA 0.093 0.075 20.032 0.084 0.622 363.56 *
SALES_TA 1.06 0.6 0.57 0.33 0.796 152.81 *
Notes: Total number of observations: 624. F-statistic and Wilk’s Lambda are used for discriminating
the solvent group from the defaulted group. The higher value of F and lower value of Wilk’s Lambda
indicate greater chance for the null of equal means of the two groups to be rejected. * denotes Table V.
significant at 1 percent or better Group statistics
JRF groups is rejected at 1 per cent or better level of significance. The result also fits well
7,3 for the discriminant function as a whole. The overall chi-square of the discriminant
function is 388.8 with degrees of freedom 5 (with probability. x2 ¼ 0:00) indicating a
very high overall significance of the model. Many other variables are also being tested;
however the variables used in the third model have the best combination with highest
level of discriminatory power.
264 The Z-score obtained in Model 3 may however suffer from the misclassification cost.
Misclassification may arise due to type I and type II errors. Type I error occurs when
the model incorrectly classifies a “bad” firm as “good”. Type II error arises when the
model identifies a “good” firm as “bad”. Obviously, type I error is more costly for bank
than the type II error. Therefore, it is necessary to estimate posterior probabilities to set
a benchmark to make a correct decision about the firm’s default status. For this, we
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estimate two separate Fisher’s discriminant equations and for a firm:

Z solvent¼ ¼ 26:812 2 1:72ðWK_TAÞ þ 3:52ðCASHPROF_TAÞ þ 3:016ðSOLVRÞ

24:757ðOPPROF_TAÞ þ 5:354ðSALES_TAÞ

Z defaulted ¼ 23:475 2 2:456ðWK_TAÞ 2 3:43ðCASHPROF_TAÞ þ 2:152ðSOLVRÞ

212:311ðOPPROF_TAÞ þ 3:81ðSALES_TAÞ

Using the above two equations, we obtain two scores for the same firm. In the next
step, the final Z-score obtained in Model 3 denotes a reduced form representation of the
above two discriminant equations (i.e. the difference between solvent and defaulted

Z ¼ Zsolvent 2 Zdefault


Z ¼ 23:337 þ 0:736ðWK_TAÞ þ 6:95ðCASHPROF_TAÞ þ 0:864ðSOLVRÞ

þ7:554ðOPPROF_TAÞ þ 1:544ðSALES_TAÞ

Accordingly we predict a firm as solvent (or non-defaulting) if the final Z-score

obtained is positive (as for him, Prob. (solvent) . Prob. (defaulted)). Similarly, the firm
with a negative Z-score is classified as one liable to default within a year horizon.

Model 1: re-worked Model 2: re-worked emerging Model 3: new Z-score

Altman (1968) (%) market (1995) (%) model (%)
Table VI.
Classification power of Defaulted no. 80 84 92
the model for the holdout correct (Type I)
dample of 25 corporations Solvent no. correct 88 84 96
for the year 2004 (Type II)
Z-score model validation Logistics and
In order to judge the correct prediction power of the discriminant function, the model Z-score model
needs to be tested with a sample that has not been used for estimation. The holdout
sample validation perhaps constitutes one of the best tests to validate the discriminant approaches
function. Further, the model should also be able to predict the default much before the
occurrence of the incident. Since we are using a balanced panel data over the period
1998 to 2003, the Z-score model should be able to capture the dynamics of default 265

Holdout sample validation

Table VI shows that when the Model 3 tested on a holdout sample of 50 companies (25
defaulted and 25 solvent) for the period 2004, it can correctly classify 92 percent of the
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defaulted firms and 96 percent of the solvent firms. However, both the type I and type
II error rates are much higher in case of Model 1 (20 percent and 12 percent
respectively) and Model 2 (16 percent each). Therefore, Model 3 has the best holdout
sample predictive accuracy.

Prediction power back in time

Having enough confirmed the predictive power of our new Z-score model; we now
check its long run predictive ability. The question we try to answer is: how far into the
future the model predicts accurately? Accordingly, we examine the overall
effectiveness of the third model for a longer period of time prior to the occurrence of
actual default. This has important strategic meaning for the banks, because the
corporation may default on bank loan much before its bond instrument publicly rated
as D. Therefore, earlier the model can identify signs of stress, lesser are the costs
involved in taking the required steps.
To test the long run accuracy of our Z-score model, we have created holdout sample
of another 37 defaulted Indian corporations and collected their financial data. These
corporations got D ratings from CRISIL between the years 1996-2005. Next, we
examine the prediction power of our model back in time from 0, 1, 2, 3, 4, 5, 6 years
prior to default. As can be seen from the Table VII that the predictive ability of the
model to identify defaulting firm falls from 88 percent one year prior to default to 45
percent as one goes back six years prior to the occurrence of default. We also compare

Model 1: re-worked Model 2: re-worked Model 3: new

Altman (1968) emerging market (1995) Z-score model
Year prior to default (%) (%) (%)

0 79 79 88
1 59 73 88
2 55 50 68
3 – – 57 Table VII.
4 – – 56 Relative comparison of
5 – – 45 classification and
6 – – 45 predictive accuracy of
three discriminant
Notes: Using a holdout sample of 37 Indian corporate bonds defaulted between the year 1996-2005. models: early warning
Also using 0 as the cutoff score signal (time dimension)
JRF the long run predictive power of our model with Model 1 and Model 2. Our model (i.e.
7,3 Model 3) clearly out performs the other two models even if one goes back two years
prior to default (with 68 percent accuracy). Moreover, the type I accuracy rate of Model
3 is pretty high (88 percent) on data from one financial statement prior to default on
outstanding bonds.

266 Testing the power of the model on distressed firm’s sample

Finally, we examine 148 distressed manufacturing firms who reported bankrupted by
Board for Industrial and Financial Reconstruction (BIFR) of India in year 2004. As
Table VIII shows, our Z-score model is still robust and can also forecast corporate
failure up to five years prior to distress. The accuracy rate is very high until two years
prior to distress (87 percent). We also compare the predictive accuracy power of our
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model with Model 1 and Model 2. It is evident from Table VIII that our model performs
much better than the other two previous models.

Logit model: estimation procedure

We have done Logistic regression analysis to investigate the relationship between
binary or ordinal response probability and explanatory variables. The method fits
linear logistic regression model for binary or ordinal response data by the method of
maximum likelihood. Like discriminant analysis, this technique weights the
independent variables and assigns a Z-score in a form of failure probability to each
company in a sample. Discriminant analysis and logit analysis have different
assumptions concerning the relationships between the independent variables. While
linear discriminant analysis is based on linear combination of independent variables,
logit analysis uses the logistic cumulative probability function in predicting default.
The logit equation we have estimated takes the following form:

PD ¼ FðZ Þ
¼ 1
1þe 2Z
¼ 1=1 þ e 2ðb0 þb1 X 1 þb2 X 2 þb3 X 3 þ...þbk XÞ

where F(Z) is the cumulative logistic distribution.

Model 1: re-worked Model 2: re-worked emerging Model 3: new

Altman (1968) market (1995) Z-score model
Year prior to failure (%) (%) (%)

0 94 95 97
1 95.3 95.3 96.3
Table VIII. 2 82.5 85 87
Relative comparison of 3 73 73 78
bankruptcy prediction 4 62 68 73.3
power of three 5 55 56 68.1
discriminant models: Notes: Using a holdout sample of 148 Indian Manufacturing Firms reported bankrupted by Board for
early warning signal Industrial and Financial Reconstruction (BIFR) of India in the year 2004. Also using 0 as the cut-off
(time dimension) score
We have applied Maximum Likelihood Estimation (MLE) procedure for estimation of Logistics and
the parameters. Z-score model
In the logit regression, our purpose is to evaluate the role of balance sheet variables
as well as the non-financial variables in predicting corporate bond default and to arrive approaches
at an estimate of probability of default for a firm using them.
Before we discuss our results, let us first look at the descriptive statistics of the
variables used in the logistic regressions. Table IX, gives us some descriptive statistics 267
about the sample of firms used in the logistic analysis. It is evident from the descriptive
statistics table that all the financial ratios for solvent group of firms on average look
relatively better than their defaulted counterparts. As far as the non-financial parameters
are concerned, the greater percentage of solvent firms possess ISO certificate than the
defaulted firm. Similarly, defaulted firms are on average younger than the defaulted
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firms. The solvent firms also mostly belong to the top 50 business groups than the
defaulted ones. The difference is also statistically significant as evident from the
t-statistics reported in column 8[5]. Furthermore, standard deviations of financial ratios
are very high for defaulted companies in comparison to the solvent firms.

Results of the logit model

We define the dependent variable by coding an indicator binary variable with a 1
(default) or a 0 (non-default). The same balanced panel data set of 104 companies (52
defaulted firms and 52 solvent firms) over the period 1998 to 2003 has been used to run
the logit model. In a stepwise logistic regression method, we finally obtain three sets of
models. In Model 1 and 2, we test financial as well as non-financial parameters that
have been discussed earlier in the variable definition section. Model 3 only explains the
role of financial factors on the probability of default by a firm. The results are
summarized in columns 2, 3, and 4 of Table X.
Model 3 (Table X) shows that the financial ratios (SOLVR, CASHPROF_TA,
WK_TA, SALES_TA and MVE_BVL) are negatively significant (5 percent or
better) on default probability. The results of Model 3 are consistent with our
theoretical expectation, which is discussed in the data and variable section. In
Model 1 and Model 2, we test the explanatory power of both the financial as well
as non-financial parameters. The financial ratios have the same expected signs as
we have found in Model 1 and 2. As far as non-financial parameters are
concerned, the age parameter LN(AGE) is negatively significant, implying that

Mean Mean t-statistics

Mean Std. dev. DEF ¼ 0 Std. dev. DEF ¼ 1 Std. dev. for difference

SOLVR 1.78 1.08 2.32 1.304 1.27 0.371 13.61 * * *

CASHPROF_TA 0.036 0.105 0.1 0.07 20.03 0.09 19.1 * * *
WK_TA 0.06 0.29 0.19 0.17 20.07 0.33 12.17 * * *
SALES_TA 0.81 0.55 1.04 0.61 0.57 0.33 11.81 * * *
MVE_BVL 1.303 4.65 2.63 6.58 0.155 0.35 6.53 * * * Table IX.
ISOD 0.57 0.49 0.69 0.46 0.46 0.50 5.99 * * * Descriptive statistics for
Dtop50grp 0.37 0.48 0.46 0.50 0.29 0.45 4.53 * * * logit model: comparison
LN(AGE) 3.22 0.78 3.46 0.77 2.99 0.73 7.78 * * * between defaulted group
No. of observations 624 312 312 and solvent group
Variables Model 1 Model 2 Model 3
DEF Coefficients Coefficients Coefficients
SOLVR 2 1.23 * * * 2 1.47 * * * 21.78 * * *
CASHPROF_TA 2 12.91 * * * 2 13.49 * * * 2 11.74 * * *
WK_TA 2 10.35 * * * 2 9.02 * * * 24.54 * * *
268 SALES_TA 2 1.67 * * * 2 1.79 * * * 21.32 * * *
MVE_BVL 2 1.74 * * * 2 1.56 * * * 21.33 * * *
ISOD 2 1.27 * * * 2 1.88 * * * –
Dtop50grp – 2 0.805 * * * –
LN(AGE) 2 1.66 * * – –
IND1 2 1.114 Dropped –
IND2 Dropped Dropped –
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IND3 0.45 2.37 * * –

IND4 1.27 2.69 * * * –
IND5 2.48 * * 3.51 * * * –
IND6 0.86 2.92 * * * –
IND7 0.46 2.08 –
IND8 Dropped Dropped –
IND9 1.49 1.57 –
IND10 2 3.52 * * * 2 1.89 –
IND11 Dropped Dropped –
Intercept 11.46 * * * 5.24 * * * 5.5 * * *
Number of Obs. 518 518 558
LR x2 statistics 492.93 (14) 469.47 (14) 437.69 (5)
Prob.. x2 0.00 0.00 0.00
Pseudo R 2 0.70 0.66 0.57
Table X. Notes: The dependent variable DEF is a default dummy; DEF=1, if the company’s long term bond is
Logit model: prediction of defaulted in any year between the year 1998 to 2003 and DEF =0, if there is no default. The model 1
default events with and model 2 use all financial and non-financial factors. Model 3 uses only financial parameters. * * *
different factor types denotes significant at 5 percent or better; * * denotes significant at 5-10 percent

younger firms are more risky than the older firms. It is more likely that matured
firms have established a reputation with credit institutes and private investors that
alleviates the asymmetric information problems because an extended period of
scrutiny would permit a better understanding of the economic viability of the firm.
In the case of a liquidity crunch, an older firm could rely on such a relationship to
obtain additional lines of credit or favorable grace periods and can avoid a
corporate default event. On the other hand, young firms have less time to solidify
a relationship with its creditors and private investors hence increasing the chance
of financial distress during a credit crunch.
Similarly, the likelihood of default is less if the firm belongs to the top 50 business
group. Likewise, the ISO dummy (ISOD) has negative influence on the probability of
default (DEF), indicating that the firms that maintain a quality management system have
less chance of default. The industry dummies are significantly different from zero
suggesting that we cannot reject the presence of industry effects on firm’s default status.
Now, let’s compare the diagnostic tests of these models. As reported in the lower panel
of Table X, Pseudo R 2 is highest (0.70) in Model 1 in comparison to Model 2 (0.66) and
Model 3 (0.57)[6]. The chi-square statistics is also highest in case of Model 1. We also
checked the predictive power of the logistic models by using ROC graphs in Figure 1 and
calculate the area under the ROC curve based on the model estimates by logit[7]. One can Logistics and
clearly see from Figure 1 that Model 1 has the highest within sample prediction power of Z-score model
97.2 percent in comparison to Model 2 and Model 3. Further, we have performed a
chi-squared test to summarize the predictive accuracy of these three models into a approaches
summary statistic. The chi-squared test yielded a significance probability of 0.001
suggesting that there is a significant difference in the areas under the three ROC curves.
Hence, it is evident from our results that inclusion of non-financial factors along with the 269
financial factors improves the default-forecasting ability of the model. The results of
Model 1 indicate a strong relationship between default and the financial and non-financial
variables. The Model 1 can be directly used for finding PDs in credit-risk models[8].
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Predictive power of the logistic model

One may again argue that model performance may be driven by type I and type II error
rates. Consequently, Model 1 has been tested in the same holdout sample that we used in
MDA analysis. The 2003 and 2004 holdout sample consists of equal number of 25 cases of
solvent and 25 cases of defaulted firms. As evident from the results reported in Table XI,
model 1 clearly shows good capacity to discriminate between defaulted and solvent firms.

Figure 1.
Comparison of ROC
curves for three models

Predicted group

Original group Defaulted Solvent Total Table XI.

Defaulted 47 3 50 Classification power of
(94%) (6%) (100%) the logistic Model 1 for
Solvent 8 42 50 the holdout sample of the
(16%) (84%) (100%) years 2003 and 2004
JRF Conclusions
7,3 Using a sample of 104 listed corporations from CRISIL, we have developed a Z-score
model for Indian firms that can accurately predict bond default one year in advance.
The model not only has a high classification power within sample (91 percent), but also
exhibited a high predictive power in terms of its ability to detect bad firms in the
two-holdout samples (with 92 percent and 88 percent accuracy rates). Moreover, the
270 model also can predict corporate bankruptcy in two years prior to financial distress
with an accuracy rate of 97 percent and 96.3 percent respectively. The new Z-score
model of this paper outperforms the other two contesting models comprising of
Altman, 1968 and emerging market score 1995 set of ratios respectively. Using our
Z-score model, banks as well as investors can get early warning signals about the firm
and might reassess the magnitude of the default premium they require on low-grade
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In the logit analysis, we link the firm’s performance with the macro economic
environment. The logit results show that PD is a decreasing function of cash profit
over total assets, working capital to assets, total sales relative to total assets, solidity,
solvency ratio, firm age, ISO certification and top 50 group affiliation. Further, industry
affiliation of a firm is also an important factor for explaining its default status and also
needs to be taken into account. From our empirical analysis we find that inclusion of
both financial and non-financial factors leads to more accurate default prediction than
the single use of accounting ratios.

1. CRISIL defines default as a credit event where the underlying corporate has missed
payments (a single day’s delay or a shortfall of even a single rupee) on a rated instrument in
terms of the promised repayment schedule. CRISIL’s rating does not factor in any post
default recovery.
2. A paired t-test on the mean asset difference between the two groups had shown statistically
insignificant results.
3. The probability of default (PD) per rating grade counts the average percentage of bond in
this rating grade in the course of one year.
4. It is empirically observed fact that the linear discriminant model has a higher holdout
sample predictive power compared to the quadratic discriminant model (Altman, 1993).
Moreover, the former is more amenable for interpretation compared to the latter.
5. A Wilcoxon rank-sum test showed that all the financial and non-financial parameters are
significantly better for solvent group (at 1 percent or better level) than the defaulted group.
6. Pseudo R 2 is a likelihood ratio index, which is analogous to the R 2 in a conventional
regression model. Here Pseudo R 2 ¼ 1 2 Lmax =L0 , where L0 is the initial value of likelihood
function and Lmax is the highest value.
7. Receiver Operating Characteristic Curve (ROC) quantifies the accuracy of diagnostic tests to
discriminate between defaulted firms and solvent firms using each value of the logit score as
a possible cutoff point. The analysis uses the ROC curves of the sensitivity (percentage of
true defaulted outcomes correctly specified) vs. 1-specificity (percentage of false defaulted
outcomes correctly specified) of the diagnostic test. This calculates the area under the ROC
curve based on the model estimated by logistic regression predictions. The greater the area
under the ROC curve, the better the predictive power of the model. Therefore, a steeper curve
from the diagonal line indicates a more powerful model.
8. From Table results of Model 1, one can estimate the probability of default (PD) by using the
Logistics and
following equation: PDi ¼ 1þexpð2z , zi ¼ a þ bX i , where a is the intercept and b represents

the parameters that may explain default incidents. Z-score model

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