Debt and bankruptcy risk · updated October 21, 2026
What is distance to default (the Merton model)
Distance to default shows how much the company's value would have to fall to drop below its debt, measured in how much that value usually moves. It uses the share price, so it changes every day, not just at earnings reports.
The distance to default formula
DD=ln(Asset value ÷ Debt) + (μ − σ² ÷ 2) × Tσ × √T
- Asset value
- The market value of the company (estimated from market cap and debt).
- Debt
- The default threshold: short-term debt plus half of long-term debt.
- σ
- The volatility of asset value.
- μ
- The expected growth in value.
- T
- The time horizon, usually one year.
How to read the distance to default
Below 1.5high risk
1.5 - 3worth watching
Above 3far from default
The distance also gives a probability of default: a distance of 3 means less than 1% probability within a year, according to the model.
When the distance to default can fool you
Choppy markets: high market volatility shortens the distance for every company at once, even with no change in the business.
Related terms
Questions about the distance to default
Who uses the Merton model?
Rating agencies and banks, for credit risk. It is the basis of the KMV model used by Moody's.
These explanations are for information only. They are not a recommendation to buy or sell.
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