Page 1 of 20

Journal for Studies in Management and Planning

Available at http://internationaljournalofresearch.org/index.php/JSMaP

e-ISSN: 2395-0463

Volume 01 Issue 10

November 2015

Available online: http://internationaljournalofresearch.org/ P a g e | 217

Prediction of Bankruptcy Risk in Indian Banks: An

Application of Altman’s Model

*Prashant Kumar **Kavita,

* Research Scholar, Dept. of Business Administration, Chaudhary Devi Lal University, Sirsa,

125055 Haryana.

Email: kumar.prashant2021@gmail.com

** Research Scholar, Dept. of Management Studies, BPS Women University, Khanpur kalan,

Sonipat, 131305 Haryana.

Email: kumar.prashant2021@gmail.com

ABSTRACT

After the financial crisis and pressure of

implementing Basel III norms, financial

solvency has become top priority for the

banking sector, because there are some

factors like failure of management,

competition, increasing NPAs, growing

incidence of fraud, inability to meet

regulatory requirements which create the

probability of risk and leads to financial

distress. In this context, measuring financial

health of a bank has become an imperative

need. Bankruptcy risk has always been a

matter of concern not only for bankers but

for all stakeholders in the business world

because the risk can seriously jeopardizes

the affairs of the business. Therefore proper

assessment of bankruptcy risk is required to

smooth functioning of banks and proper

implementation of Basel III regulations. It is

contemporary to study solvency position of

Indian banks. The axle of this study is to

predict the financial health and risk of

bankruptcy by applying Altman Z Score

model in the selected Indian banks. This

model highlights that the position of the

banks, under study is healthy and

comparatively sound. It can be concluded

that the selected Indian banks which are

under study falls in ‘safe Zone’ as per Z- score criteria and there is not any chance of

financial distress.

Keywords: Bankruptcy risk, EBIT,

Financial health, financial ratios, Z-score.

INTRODUCTION

Banks play significant role in the financial

stability of any economy as banking sector

is the main component of financial system.

A stable and financially sound banking

system leads to economic development of

any country. Now these days, financial

stability has become the major issue for

banking sector because there are some

factors such as failure of management,

external factors, competition, increasing

portfolio of NPA, growing incidence of

fraud, inability to meet regulatory

Page 2 of 20

Journal for Studies in Management and Planning

Available at http://internationaljournalofresearch.org/index.php/JSMaP

e-ISSN: 2395-0463

Volume 01 Issue 10

November 2015

Available online: http://internationaljournalofresearch.org/ P a g e | 218

requirements which create the probability of

risk and leads to financial distress. Banking

sector faces various types of risk viz. credit

risk, market risk, liquidity risk, foreign

exchange risk, political risk, sovereign risk,

interest rate risk, operational risk etc. and

high intensity of risk leads to business

failure (Campbell 2007).

There are five stages of business failure such

as incubation, financial embarrassment,

financial insolvency, total insolvency and

confirmed insolvency (Fitzpatrick 1932).

Bankruptcy or insolvency is the form of

financial failure refers to where a firm

cannot meet its current obligations, when the

current obligations exceed the current assets.

Bankruptcy is a severe matter and very

common thing among companies and

financial institutions. There may be many

reasons like changes in market policy,

inflation and political reasons which have

led to bankruptcy (Movaziri et al, 2012).

Bankruptcy can be used as a proxy for

measuring economic sustainability. Because

it is considered that bankrupt banks have

weak position while non-bankrupt banks

have strong economic sustainability and

long term survival (Amin Jan et al, 2015).

Global financial crisis blessed with inflation,

currency deterioration, economic

uncertainty, high interest rates and many

other uncontrollable factors was enough to

break down the resilience of financial sector.

The Financial soundness of banking sector is

backbone of every economy. In this context,

it is very crucial to analyze the financial

soundness of domestic banks (Nishi sharma

et al, 2013). Bankruptcy prediction is of

immense importance to both for lenders as

well as for the investors. There are many

techniques that have developed to assess the

bankruptcy risk. Bankruptcy is a worldwide

problem. Bankruptcy histories shows that a

company with efficient management, strong

financial performance and capable to grow

without any distress symptoms, can be

turned out to be a sudden bankruptcy. In the

period from 2000 to 2011, it has been

witnessed a wave of bankruptcies in the

giant companies like, Lehman Brothers,

Enron give examples to the world that no

matter how strong the company is, it can

face bankruptcy if it is not well managed.

On 30th November 2001, Enron bankruptcy

was reported and appealed for bankruptcy

protection on the 2nd of December 2001.

The other company is Lehman Brothers

which was the fourth largest investment

bank in US. Lehman filed for bankruptcy

protection in 2008 to avoid the possibility of

being distressed (Anita et al, 2013). There is

a dire need to manage risk of bankruptcy as

it is the critical issue for banks. Prediction of

bankruptcy is one of the challenging task for

every organization (Fawad et al, 2014). In

2008, the largest bankruptcy in U.S. history

represents an example for Indian banks to

manage their cash flows efficiently .Thus

careful attention to the impact of bankruptcy

risk level on bank’s profitability is necessary

because intense risk puts serious threat to

banks and increasingly level of risk may

create a chance of closing down the bank’s

operations. Financial soundness is of prime

importance in the current crisis and financial

scams scenario in the banking sector (Parul

Page 3 of 20

Journal for Studies in Management and Planning

Available at http://internationaljournalofresearch.org/index.php/JSMaP

e-ISSN: 2395-0463

Volume 01 Issue 10

November 2015

Available online: http://internationaljournalofresearch.org/ P a g e | 219

Chotalia 2014). In the wake of the financial

crisis of 2008, Basel-III accord was released

in 2010. The New Basel Capital Accord

(popularly known as Basel-III) is desirable

regulation and major agenda for the

commercial banks in India and across the

world. The main focus of Basel-III is on the

estimation of capital requirements which

would ensure financial stability and

determine the common standards of banking

regulation. From the perspective of Basel

III, to maintain the higher capital

requirements and to comply with Basel III

norms are the concerned areas for banks.

Thus, Indian banking sector need to predict

bankruptcy risk and analyze their financial

statements because the risk of bankruptcy

directly hits the financial strength and

earnings of banks. Therefore proper

assessment of bankruptcy risk is required to

smooth functioning of banks and proper

implementation of Basel III regulations. The

prediction of business failure is an important

step for taking timely corrective and

remedial measure for protecting business

from the problem of bankruptcy. The basic

concern of prediction is to evaluate the

terms of credit and ensure repayment safely

(Roli Pradhan 2014). The problem of

business failure is attributed to both

financial and non-financial causes such as

poor planning, inefficient management and

fraud. There is need for predicting financial

failure on time for taking curative measures

in relation to financial investments (Venkata

Ramana et al, 2012).

There are many different models to forecast

the complex problem of bankruptcy. There

may be many internal credit rating model

used for bank which improves their current

predictive power of financial risk factors and

explained how banks assess the credit

worthiness of the borrowers and how can

they identify the defaulters so as to improve

their credit evaluation process (Kishore

Navin 2011). Many internal and external

users of financial statements like banks,

credit rating agencies, underwriters,

auditors, policy makers and regulators

analyze company’s financial position. For

this purpose different approaches and

models are used. During financial and

economic crisis selection of model for

bankruptcy prediction is essential. For

example when bank financially assists a

company, bank predicts risk of bankruptcy

of that company prior to financial help. The

prediction models are used to check the

bankruptcy and can be applied to modern

economy to predict distress and bankruptcy

of one, two and three years in advance

(Sanobar Anjum 2012). But the most

influential model is Altman Z score model

due to most acceptable and widely used. The

well-known Altman model developed by

Edward Altman in 1968 called Z score

model has been identified as independent

variables (financial ratios) as well as the

relative weight of each variable which

represents dependent variable (Z) through an

analytical study of a sample of US

companies in 1968 (Ali Abusalah et al,

2012).