Measuring Financial Distress of IDBI Using Altman Z-Score Model

-Krishna Chaitanya V

In a recent move, the Reserve Bank of India has approved the merger of IDBI (Industrial
Development Bank of India) and IDBI Bank, which will happen in the month of October 2005. It is
said that the merged entity would be the fifth largest bank in India after SBI (State Bank of India),
ICICI (Industrial Credit and Investment Corporation of India), PNB (Punjab National Bank) and
Canara Bank, in terms of total assets. The swap ratio is fixed at 1:1.42 and the government's
holding is all set to come down to 51.4% from the present 59%. Sources also revealed that the
new entity would have two strategic units: IDBI banking and IDBI development finance. But many
experts do believe that this move of merging a weak organization with a stronger one is not a
good strategy. In the light of the above, the present study attempts to examine the financial
distress of IDBI using the Altman Z-score model. Based on the study results, the paper also
focuses on suggesting the appropriate strategy.

Introduction

The major participants of the Indian financial system are the commercial banks; financial
institutions (FIs), encompassing term-lending institutions; investment institutions; specialized
financial institutions; and the state-level development banks, nonbank financial companies
(NBFCs) and other market intermediaries such as the stockbrokers and moneylenders. The
commercial banks and certain variants of NBFCs are among the oldest of the market participants.
The FIs, on the other hand, are relatively new entities in the financial market place.

The Indian financial system comprises the following institutions:

1. Commercial Banks

a. Public Sector Banks

b. New Private Sector Banks

c. Old Private Sector Banks

d. Foreign Banks

2. Cooperative Institutions

a. Urban Cooperative Banks

b. State Cooperative Banks

c. Central Cooperative Banks

3. Financial Institutions

a. All India Financial Institutions

b. State level Financial Corporations

c. State Industrial development Corporations

4. Non-Banking Finance Companies

5. Capital Market Intermediaries

About 85-90% of the country's banking segment is under State control, while the balance
comprises the private sector and foreign banks.

Role of Financial Institutions in India

The specialized financial institutions were established to resolve market failures in developing
economies and shortage of long-term investments. The first financial institution to be established
was the Industrial Finance Corporation of India (IFCI) in 1948. This was followed by the State
Financial Corporation (SFC) at the state level, which was set up under a special statute. In 1955,
the Industrial Credit and Investment Corporation of India (ICICI) was set up in the private sector
with foreign equity participation. This was followed in 1964 by the Industrial Development Bank of
India (IDBI), which was set up as a subsidiary of the Reserve Bank of India (RBI). The three
institutions that dominate the term-lending market in providing financial assistance to the
corporate sector are IDBI, IFCI and ICICI.

In India, financial institutions were established and developed by the Government of India and
Reserve Bank of India to meet the specific needs of industry and were traditionally engaged in
long- term financing, since their main objective was to take care of the investment needs of
industries and to contribute to a better industrial climate.

Role of Commercial Banks in India

Traditionally, the commercial banks in India were largely into the core banking business of
accepting deposits and providing working capital funds to agriculture and allied trade and industry
sectors.

At present, Indian banks are engaged in credit, consumer finance, savings, money and capital,
advisory services and, recently, the insurance market.

The traditional division between banks (as providers of working capital) and FIs (as providers of
project finance) is increasingly getting blurred with the deepening of financial reforms and
integration of financial markets. The need was felt to gradually put in place a regulatory
framework which will facilitate eventually the transition to universal banking. The Reserve Bank of
India undertook a number of policy measures relating to financial institutions during 1999-2000.
One such option was the merging of financial institutions with strong and viable commercial banks.
As a part of this strategy, ICICI was merged with the ICICI bank in the year 2001.

In a recent move, the Reserve Bank of India has approved the merger of IDBI and IDBI bank
which will happen in the month of October 2005. The modalities have also been worked out as the
swap ratio is fixed at 1:1.42 and the government's holding is all set to come down to 51.4% from
the present 59%. But many financial experts are arguing that this is not a good strategy because
it does not make any logical sense of merging a weak organization with the stronger ones.

Table 1: Roles of Commercial Banks and Financial

Institutions (FIs)
 Commercial Banking or Investment Other Financial
 
Similar in Nature Banking Services
Banks Accepting chequable Investments in Factoring,
deposits Granting loans securities Leasing, Hire
and advances Underwriting of
purchase,
Mutual funds,
issues Loan
Credit-cards,
syndication Merchant
banking,
Housing Finance
FIs Granting long-term Underwriting Commercial
loans and advances, and subscribing banking, Credit
Granting short-term directly to rating,
loans/advances/working shares/bonds Brokerage, H.F,
capital finance, of corporates. M.Fs, Project
Accepting term-deposits consultancy,
and issuing CDs, etc. Registrar
services, etc.
Notes:

- Source:www.rbi.org.in

- The activities are performed either directly or through

subsidiaries.

- FIs: Financial Institutions

- CDs: Certificate of Deposits

- M.Fs: Mutual Funds

- H.F: Housing Finance

Objectives of the Study

In the light of the above discussion, an attempt has been made in this paper to predict the
insolvency of IDBI. Thus, the basic objectives of the study are:

1. To find out the financial distress of IDBI using the Altman Z-Score model.

2. To explore the signs of financial distress of IDBI and address the issue of the proposed merger
plan of IDBI with IDBI bank based on the results.

Methodology

The Z-Score is a measure of a company's health and utilizes several key ratios for its formulation.
In the year 1968, Professor Edward I Altman, using the Multiple Discriminant Analysis, combined a
set of five financial ratios to come up with the Altman Z-Score. This score uses statistical
techniques to predict a company's probability of failure using the following eight variables from a
company's financial statements:
1. Earnings Before Interest and Tax (EBIT)

2. Total Assets

3. Net Sales

4. Market Value of Equity

5. Total Liabilities

6. Current Assets

7. Current Liabilities

8. Retained Earnings

1. The X1 Component of Z-Score is defined as:

X1 = Earnings before Interest and Taxes/Total Assets

This ratio adjusts a company's earnings for varying factors of income tax and makes adjustments
for leveraging due to borrowings. These adjustments allow more effective measurements of the
company's utilization of its assets.

2. The X2 Component of Z-Score is defined as:

X2 = Net Sales/Total Assets

This ratio measures the ability of the company's assets to generate sales.

3. The X3 Component of Z-Score is defined as:

X3 = Market Value of Equity/Total Liabilities

This ratio gives an indication of how much a company's assets can decline in value before debts
may exceed assets. Equity consists of the market value of all outstanding, common and preferred
stock. For a private company, the book value of equity is used for this ratio. This depends on the
assumption that a private company records its assets at market value.

4. The X4 Component of Z-Score is defined as:

X4 = Working Capital/Total Assets

The ratio of Working Capital to Total Assets is the Z-Score component, which is considered to be a
reasonable predictor of deepening trouble for a company. A company which experiences repeated
operating losses generally suffers a reduction in the working capital relative to its total assets.

5. The X5 Component of Z-Score is defined as:

X5 = Retained Earnings/Total Assets

The ratio of Retained Earnings to Total Assets is a Z-Score component which provides information
on the extent to which a company has been able to reinvest its earnings in itself. An older
company must have had more time to accumulate earnings, so this measurement tends to create
a positive bias towards older companies.

The five financial ratios in the Altman Z-Score and their respective weight factors are shown in
Table 2.

Table 2: Financial Ratios and Weights

Ratio Weight
A. EBIT / Total Assets 3.3
B. Net Sales / Total Assets 0.99
C. Market Value of Equity / Total
0.6
Liabilities
D. Working Capital / Total Assets 1.2
E. Retained Earnings / Total Assets 1.4

These ratios are multiplied by the weightage as above, and the results are added together.

Thus,

Z-Score = A x 3.3 + B x 0.99 + C x 0.6 + D x 1.2 + E x 1.4

Interpretation of Z-Score

Table 3: Z-Score and Interpretation

The company is safe based on these financial figures
Above 3.0
only.
Between 2.7 On Alert. This zone is an area where one should
and 2.99 exercise caution.
Good chance of company going bankrupt within 2
Between 1.8
years of operations from the given date of financial
and 2.7
figures.
Below 1.80 Probability of financial embarrassment is very high.

Scope of the Study

The proposed study will be confined only to measure the insolvency of IDBI.

Sources of Data

The proposed study will be based mainly on secondary data. The data for computation of the ratios
for the study period is taken from the database of Capitoline Plus. However, some data relating to
the financial position and other information of the IDBI is taken from its website.

Period of Study

The proposed study will be conducted in a span of nine months, starting April 2004 and ending
December 2004. Collection of secondary data related to trends in sales, EBIT and rate of growth of
various key financial variables will be taken of the last ten years.
Literature Review

In the early 1930s, the research period of failure prediction, there were no advanced statistical
methods or computers available for the researcher scholars and analysts. Research was based
purely on ratio analysis. The values of financial ratios in failed and non-failed firms were compared
with each other. In 1966, the pioneering study of Beaver presented the univariate approach of
discriminant analysis model to determine the financial ratios that measured profitability, liquidity
and solvency. Later, Edward Altman, (1968) using the period 1946 to 1965, studied 33
manufacturing companies which had filed for bankruptcy. He used financial ratios-by applying the
multiple discriminant analysis-to predict which of the 66 sample firms would go bankrupt.

There are a good number of previous studies addressing the prediction of bankruptcy in the United
States of America, which gives a glimpse on the bankruptcy predictions, some well-known
published contributions are Beaver (1968), Meyer and Pifer (1970), Deakin (1972), Edmister
(1972), Altman and McGough (1974) and Altman, Haldeman, and Narayanan (1977).

Cindy Yoshiko Shirata (1998) predicted the bankruptcy of Japanese firms using financial ratios.
The paper presents some empirical results of a study regarding predictors of Japanese corporate
failure as evidenced by the event of bankruptcy of 686 firms in Japan in the year 1997 alone. The
paper by Rasheed (1997) on financial distress gives a detailed insight on the usage of Multi
Discriminate Analysis (MDA) to discriminate between the characteristics of a financially distressed
firm and a nonfinancially distressed one, combining traditional ratio analysis with statistical
techniques. Jonah Aiyabei (2002) examined the financial performance of small business firms
based on the Altman Z-Score model in her work on the theory, measurement and consequence of
financial distress.

In their paper, "The Identification of Corporate Distress in UK Industrials: A Conditional Probability

Analysis Approach", Lin Lin and Jennifer Piesse (2004) applied the alternative approach based on
Conditional Probability Analysis (CPA) models to forecast mergers and acquisitions, which
extended to the prediction of corporate failure. Elizabeth K Keating, Mary Fischer, Teresa P
Gordon, Janet Greenlee (2005) conducted a study on assessing the financial vulnerability in the
nonprofit sector using the Altman Z-Score model. Amanda Allmon's work on simple regression and
financial statement analysis (2004) examined whether there were any differences in the ratios and
potential predictors of income in a company which are known to have produced fraudulent financial
statements. The study revealed that fraudulent or potentially fraudulent reporting companies had
significant Z-Score regressions, while `non-false' financial reporting companies did not have
significant Z-Score regression results. William D Biggs and Jennifer L Biggs (1995) used Altman Z-
Score model to conduct preliminary investigation of the use of the bankruptcy indicator in a
simulation environment.

In India, some notable study on measuring the financial performance of banks and nonbanking
finance companies has been accomplished. Amita S Kantawalla (2001-02) provides insights into
the financial performance of NBFCs in India from the period of 1984 to 1995. Her study on the
soundness of public sector banks (2004) gives a detailed description of the key variables and their
relationship with a bank's riskiness index.

A study by T S Harihar (1998) throws light on the performance of all NBFCs in India, taking
together certain key ratios An empirical analysis of the determinants of performance differences
among commercial banks in Nigeria is well detailed in the paper by Ralph I Udegbunam (2001).
Bharathi V Pathak (2003), in her research on comparing the financial performance of private
sector banks, judges the performance of five new private sector banks using the parameters like
deposits, profits, ROA and productivity.
The conceptual paper by Krishna Chaitanya V (2005), "Universal Banking - The Indian
Perspective", throws light on how and why new private sector banks are forced to offer all financial
services under one roof to their customers in India and its impact on the financial institutions for
converting themselves into commercial banks.

IDBI: The Organization Profile

IDBI, the country's premier financial institution, was established in July 1964 by an Act of
Parliament as a fully owned subsidiary of the Reserve Bank of India. The ownership of the latter
was transferred to the Government of India in 1976. It played a dominant role in the balanced
development of the industrial sector.

IDBI's strategic objective was to position itself as India's premier wholesale bank through a full
range of wholesale products-lending, capital markets, advisory and risk management, through an
integrated group structure and to provide financial assistance for the establishment of new
projects as well as for expansion, diversification, modernization and technology updating of
industrial enterprises. In July 2000, Government converted 247 million equity shares to preference
shares, reducing its equity stake to 58%. IDBI also has its arm in the housing sector as it floated a
wholly-owned housing finance subsidiary with a capital base of Rs. 100 cr for its entry in this
sector.

Most importantly, as a long term strategy, steps have been initiated by IDBI to reposition itself by
transforming into a universal bank, consolidation of business, diversification of portfolio,
maximization of recovery, management of non-performing assets (NPAs) and cost cutting. It
retained the services of Boston Consulting Group to prepare the roadmap for organization and
business restructuring to transform IDBI into a globally competitive universal bank utilizing the
operational synergy of the IDBI group in the process.

As per the recommendations of the Consulting Group, the Board of Directors of IDBI approved the
scheme of amalgamation, envisaging merging of IDBI Bank Ltd. with IDBI Ltd.

IDBI and IDBI Bank: The Merger Proposal

The proposed merger of the term-lending institution, IDBI, with a 57% government holding, with
its private banking arm IDBI Bank is set to create the seventh-largest bank in India with an asset
base worth Rs. 80000 cr and liabilities of Rs. 15000 cr.

IDBI currently holds 56% in IDBI Bank, SIDBI holds 17%, while 5% is held by the bank
employees. The remaining 21% is held by the public. Unlike its rival ICICI, which reverse-merged
with ICICI Bank, this will be a straight merger between two entities. Post-merger, the new entity,
IDBI, will function as a strategic business unit with two main focus areas-project finance and retail
lending. The merger comes at a time when IDBI's development-banking model is no longer
relevant in the new market-oriented environment.

Table 4: Key Financial Items of IDBI and IDBI

Bank
Items IDBI bank IDBI
Equity paid-up (Rs. cr) 140.08 652.83
Net worth (Rs. cr) 354.29 6978.09
Sales (Rs. cr) 598.08 6227.53
Net profit (Rs. cr) 71.10 401.41
 Book value (Rs.) 25.29 106.89
Deposits (Rs. cr) 6032.3 N.A
Borrowings (Rs. cr) 1041.49 N.A
Advances (Rs. cr) 4325.19 50487.29
Gross NPAs (Rs. cr) 115.17 7329.94
CAR (%) 9.56 18.72
Return on Assets (%) 0.90 0.62
Business/Employee (Rs.
7.10 30.00
cr)
Profit/Employee (Rs. cr) 0.05 0.14
Source: Capitaline Plus

Ahead of the much awaited merger, the IDBI Act was repealed and the institution converted itself
into a commercial bank on October 2004. This is expected to make IDBI, with net assets worth Rs.
58000 cr, a deemed banking company. The banking license has allowed it to have access to cheap
retail deposits, an area restricted by term lenders.

Some experts believe that the merger, with its private banking arm having a 9% CAR (Capital
Adequacy Ratio), is a win-win situation for both the entities. It enables IDBI to function as a full-
fledged deposit-taking bank without incurring expenditure on setting up branches, inducting
technology or bringing in new people.

It grants the financial institution a readymade technology platform with access to IDBI Bank's 99
branches and 299 ATMs across 69 cities, consumer banking skills and, most importantly, a private
sector culture. Founded a decade ago, IDBI Bank, with a deposit base of Rs. 11000 cr, has NPA
worth 0.2% of net loans. IDBI Bank also benefits with the proposed merger. Besides getting to use
the brand name of IDBI, it gets access to a wide distribution network with the 100 branches of
IDBI and also gets the necessary capital to grow and branch out.

Quantitative Measure of Financial Performance of IDBI and Results

According to the interpretation of Altman Z-Score, the probability of financial embarrassment for
anything below the score of 1.8 is very high. This is quite evident in the case of IDBI as can be
seen from its volatile and highly fluctuating financial figures of the last ten years.

Table 5: Key Financial Ratios of IDBI for 2004

Ratio
              Ratio Weight
Values
a.  EBIT / Total Assets 0.129 3.30
b.  Net Sales / Total Assets 0.195 0.99
c.  Market Value of Equity / Total
0.978 0.60
Liabilities
d.  Working Capital / Total Assets 0.100 1.20
e.  Retained Earnings / Total Assets 0.025 1.40

Concluding Remarks

This paper has essayed the financial distress aspect of IDBI and proved that IDBI had indicated its
worse financial position for a considerable time before they actually started reviving. Using the
Altman Z-Score for the current year, it has been proved here that IDBI is likely to become
insolvent in the years to come.
In the light of the above, the paper explains the danger of merging a relatively weak organization
with a stronger ones. As strategy experts always argue that an appropriate strategy would be to
merge a strong organization with other relatively stronger ones, rather than merging a weak
organization with the strong ones. Therefore, the discussion on whether the integration strategy of
merging IDBI with IDBI Bank holds good or not is still debatable.

However, more extensive study and research in the near future is recommended to come out with
valid conclusions on the appropriateness of the merger of IDBI with IDBI Bank.