Insolvency prediction for assessing corporate nancial health

, Department of Transportation, Faculty of Technical Sciences, DRAGAN SIMIC University of Novi Sad, 21000 Novi Sad, Serbia. E-mail: dsimic@eunet.rs
Department of General Technical Discipline, Faculty of C, ILIJA KOVA CEVI Technical Sciences, University of Novi Sad, 21000 Novi Sad, Serbia. E-mail: ilijak@uns.ac.rs

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

Department of Neurology, Medical School, University of SVETLANA SIMIC, Novi Sad, 21000 Novi Sad, Serbia. E-mail: drdragansimic@gmail.com Abstract
The prediction of corporate nancial failure, crucial for the prevention and mitigation of economic downturns in a national economy, requires the categorization of healthy and unhealthy companies. This study examines the case of Serbia and applies multivariant statistical methods and specic articial neural network architecturesthe self-organizing map (SOM)to assess the corporate nancial health of various companies. Financial ratios drawn from corporate balance sheets become the independent variables in a multivariate discriminant analysis (MDA). These nancial ratios and the discriminant Z -score in the MDA form the input for the SOM, which creates a hybrid MDA-SOM model that is capable of predicting corporate nancial insolvency. The experimental results of this research correctly estimate company nancial health in 95% of cases. These are reliable predictions that are comparable with similar studies in other countries. Keywords: Corporate nancial health, corporate insolvency, multivariate discriminant analysis, self-organized maps.

1 Introduction
Corporate nancial failure prediction is crucial for the prevention or mitigation of negative economic cycles in a national economy. Corporate insolvency prediction models help to identify future business failures and provide early warnings of future nancial distress. They assess corporate nancial health in industry, and especially the nancial sector. The absence of early warning systems does nothing to stop nancial upheaval such as the collapse of the Thai nancial sector in 19971998 [30]. During the recent East Asian economic crisis, trading in the shares of 58 out of 91 nancial companies was suspended in the second half of 1997, and another 12 nance companies suffered the same fate in 1998. The only bright side of any economic crisis, however, is the opportunity to examine failure prediction models for nancial institutions. In general, predictive models warn auditors of a companys vulnerability and protect them against charges of wilful breach of duty for failure to disclose potential insolvency and corporate distress [19]. Corporate distress can, within a relatively short time span of one or two nancial years, lead a company to bankruptcy, which entails signicant private costs for many parties, including shareholders, debt nancers, employees, suppliers, customers and managers. All of these stakeholders share a legitimate interest in monitoring the nancial health of a company.
The Author 2011. Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oup.com doi:10.1093/jigpal/jzr009

Assessing corporate nancial health

537

Economic and nancial theories on company failure do not provide a rigorous basis for selecting particular ratios. As a result, empirical studies on failure prediction models for industrial companies usually examine standard sets of nancial ratios that are considered important when explaining corporate nancial health. Indeed, a very natural set theory, which overcomes certain formal limitations of contemporary economic theory, may exist [32]. All of these models serve to help managers track a companys performance over many years and identify important trends. The research of Chung et al. [11] into insolvency prediction for the nancial industry in New Zealand is the inspiration for this article, which proposes improvements to their model by applying a specic articial neural network (ANN) topologyself-organizing maps (SOMs) [20]. This study aims to apply multivariant statistical methods and ANNs topology (SOM) to the assessment of corporate nancial health over two nancial years (20082009) in Serbia. The following sections provide a brief overview of hybrid articial intelligence (AI) systems and some background models for corporate insolvency prediction. Section 3 sets out a comprehensive review of the literature on nancial failure prediction. Section 4 describes the conceptual model for insolvency prediction advanced by Chung et al. along with some suggestions for its improvement. Section 5 presents an applied empirical analysis, the development of the data set, a discriminant estimation model and the batch training algorithms. Section 7 presents the experimental results, while section 8 contains the nal conclusions and outlines future areas of research.

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

2 Background
Articial intelligence techniques have demonstrated a capability to solve real-world problems in science, business, technology and commerce. The integration of different learning techniques and their adaptation, which overcomes individual constraints and achieves synergetic effects through hybridization or fusion, has in recent years contributed to a large number of new intelligent system designs [1]. The hybridization of intelligent techniques, drawn from different areas of computational intelligence, has become prevalent because of the growing awareness that they outperform individual computational intelligence techniques. In a hybrid intelligence system, a synergetic combination of multiple techniques is used to build an efcient solution to deal with a particular problem [12]. Nowadays, hybrid AI systems research encompasses many domains: cardiologyhybrid decision support system for endovascular aortic aneurism repair follow-up [21]; neurologyrule-based fuzzy logic system for diagnosis of primary headaches [29]; and meteorologyhybrid soft computing models to identify typical meteorological days [13]. One innovative research area that uses fusers as part of a multiple classier system, which is discussed in designing fusers on the basis on discriminantsevolutionary and neural network methods of training [36], could form part of future research into corporate insolvency prediction and the assessment of corporate nancial health. Assessment presents a categorization problem in order to categorize companies as either healthy or unhealthy. The leading causes of corporate failure are often divided into: economic, nancial, fraud or disaster [4]. Among the economic factors gure industrial weaknesses and poor locations, while the most widely recognized nancial factors are excessive debt and cash ow problems. Financial difculties are often the result of managerial neglect.

2.1 Financial ratios analyses

Financial ratio analyses are a stimulus to good managerial practice and are often applied in various corporate appraisals. They are particularly useful in strategic management, which seeks to address the

538 Assessing corporate nancial health future survival of corporate businesses. Financial ratio analysis, therefore, forms a very important aspect of corporate diagnosis and general business information and provides a very quick and effective snapshot of a companys operations and performance. Conventional ratio analysis involves calculating single ratio values by employing two nancial values. There are four broad categories of traditional ratios: Leverage: equity market value over total debt (MKTCAPTL), equity market value over total assets (MKTCAPTA), equity market value over total equity (MKTCAPEQ), debt over equity ratio (DERATIO), nancial leverage multiplier (TAEQ), xed assets over equity and long-term liability (FAEQLTL) and retained earnings over total assets (RETAINTA). Protability: return on assets (ROA), return on equity (ROE), gross prot margin (GRMARGIN), net prot margin (NPMARGIN), operating prot margin (EBITSALE) and EBIT over total assets (EBITTA). Turnover: working capital over sales (WCSALES), inventory turnover (INVETURN), xed assets turnover (FATURN), total assets turnover (TATURN), equity turnover (EQTURN), inventory over sales (INVSALES), receivable turnover (RECETURN), quick assets over sales (QUISALES) and current assets over sales (CASALES). Liquidity: working capital over total assets (WCTA), cash ratio (CASHCL), cash over total assets (CASHTA), cash over sales (CASHSALE), current ratio (CCRATIO), current assets over total assets (CATA), current liability ratio (CLEQUITY), quick ratio (QUIRATIO), quick assets over total assets (QUITA) and inventory over current assets (INVECA). Equally, the use of other groups of ratios depends on the nature of the nancial study, which may use similar or different nancial ratios such as, for example, the CAMELS rating system: capital adequacy, asset quality, management quality, earnings, liquidity and sensitive market risk.

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

2.2 Insolvency prediction models 2.2.1 Univariate and multivariate statistical methods
The earliest insolvency prediction models employed nancial ratios using univariate statistics. Beaver designed experimental models that use nancial ratios for examining corporate failure [6]. They follow a univariate analysis that examines the relationship between individual nancial ratios and insolvency. He concluded that single best predictor is cash ow to debt ratio. However, models which focus on a single ratio are simplistic and unable to grasp the complexity of nancial failure. As is well known, the nancial status of a company is multidimensional nowadays and no single measure is able to grasp all of its dimensions. Extensive research into the prediction of nancial failure has continued apace since the late 1960s, by applying a variety of statistical methods to solve bankruptcy prediction problems. Statistical methods include linear discriminant analysis (LDA), multivariate discriminant analysis (MDA), quadratic discriminant analysis (QDA), multiple regression, logistics regression analysis (LRAlogit), probabilistic regression (probit), k -means cluster analysis (CA) and factor analysis (FA). Altman built on Beavers work, but instead of a univariate approach he used MDA to examine corporate failure [2]. Multivariate statistical methods such as MDA require uncorrelated variables. However, to construct an optimal multivariate predictive model, one must determine which ratios are best at detecting potential failures, and the most appropriate model weightings in each case. MDA computes the discriminant coefcients and selects the appropriate weights, which will separate out the advantage values of each group, while minimizing the statistical distance of each observation

Assessing corporate nancial health

539

and its own group means. Altman employed MDA to construct a predictive algorithm based on ve key nancial ratios (WCTA, RETAINTA, EBITTA, MKTCAPTL and TATURN) to calculate the Z -score (1). Cash ow and debt ratios appeared to be important predictors of bankruptcy. In his rst research, the predictive algorithm correctly differentiated 94% of failed companies with data 1 year ahead of failure. Z = 0.012 WCTA + 0.014 RETAINTA + 0.033 EBITTA + 0.006 MKTCAPT + 0.999 TATURN (1) Other studies that adopt the MDA approach include [8] and [15]. These studies inspired other research models to predict corporate failure including: LRA [25] and recursive partitioning analysis [17]. A variety of statistical methods and ANN topologies have been applied to solve the bankruptcy prediction problem.

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

2.2.2 Challenges for an ANN prediction model

In spite of the success of ANN models, the research community should address a number of open issues. Even though prediction of a default event is in itself very useful, an estimate of a default probability is also highly desirable. Banks typically have several prediction systems in place as they are essential for computing loss levels in portfolio credit risk estimation. They also make lending decisions based on the contribution of these predictions. Thus, a default probability rather than a (binary) default prediction is a valuable resource for banks. Even though there are some objective function measures to achieve that, such as the cross-entropy error function [7], experience with this objective function is not always favourable. ANN and data-mining techniques can complement and improve the accuracy of nancial distress prediction models [10]. This opens up new possibilities in the modelling of hybrid systems for corporate insolvency prediction. Another avenue of research considers macroeconomic indicators as input to the neural networks (NN). The prevailing economic condition (as well as the current interest rates, gross domestic product (GDP), unemployment rates, price indices, ination, investment, international trade and international nance) can have a signicant effect on the probability of bankruptcy. However, very few studies consider these factors in conjunction with NN models.

3 Literature review
The development of Articial Intelligence has contributed to the emergence of new techniques such as ANNs for nancial distress prediction. In 1993, an ANN methodology for the analysis and prediction of bankruptcy was introduced in Spain for the rst time. The model was applied to 66 banks, 29 of which went bankrupt. Its authors obtained a very high classication percentage for this nancial service industry. Their approach to the problem was to establish a procedure that incorporates NN in the classication of company health. Martinez [23] describes a neural network of 70 insurance companies (35 bankrupted and 35 active). The same 24 ratios in the earlier study were applied. The results correctly classied around 96% between the rst and the fourth year preceding the crisis, while the percentage in the discriminant analysis varied between 72% in the second year and 92% 1 year prior to distress. Rey [27] applied a neural network model for nancial distress prediction which operates by selecting a sample of non-nancial companies with suspended payments or that went bankrupt during a 3-year period (from 1994 to 1996). The sample consisted of 194 companies and involved

540 Assessing corporate nancial health the calculation of 71 nancial ratios. The model correctly classied 84 (95%) out of 88 rms 1 year before crisis and 70 (83%) out of 84 companies in the following year. Gonz ales et al. [18] examines a neural network technique applied to 444 companies, half of which were insolvent. Financial ratios for protability, liquidity, growth and structure were used as independent variables. The model correctly classied 92% of companies, as well as the nancial ratios with signicant predictive power and those for protability and generation of cash ow. A study of 100 companies from Galicia (Spain) in [14] used a neural network model. Its objective was to correctly distinguish between companies in distress and nancially sound companies. Introducing 17 nancial ratios, the authors obtained ratings of 95 and 93%, respectively, for the rst and the second year prior to the crisis. In [33], the results from a logit model and from a neural network model are compared, both of which were applied to a sample of 450 companies over a 2-year period (19981999). The study concluded that neither model was superior. Andres [5] conducted a comparative study of the classication percentages for a neural network model that uses both logit and MDA. This study employed 25 ratios drawn from the nancial statements of 1636 companies, half of which were in distress. The MDA was a better predictive model than the neural network which in turn outperformed the logit model. The use of NNs for bankruptcy prediction began in the 1990s and continues to be an active area of research. Various reasons suggest that a non-linear rather than a linear approach is the best option; one of which relates to the saturation effect in the relationships between the nancial ratios and the prediction of default. Both [34] and [35] discuss NNs in business applications and contain sections on bankruptcy prediction. Moreover, [16] conducts a survey on the classical empirical approach, while [37] includes a concise review of existing work on NN bankruptcy prediction. The majority of the NN approaches to default prediction use multilayer networks. In one of the rst such studies, [24] looked at the bankruptcy prediction problem in the 1990s. In this study, Altmans nancial ratio (described above) is the input to the NN, and his methods are applied to a number of bankrupt and solvent US rms, along with MDA for comparative purposes. The data used for the bankrupt rms were taken from their last nancial statements before bankruptcy was declared. A total of 128 rms were included, and several experiments were performed, in which the proportion of bankrupt/healthy rms in the training set has been varied. The NN achieved a Type I correct classication accuracy in the range of 7781% (depending on the training setup), and a Type II accuracy in the range of 7886%. The corresponding results for MDA were in the range of 5970% for Type I accuracy, and in the range of 7886% for Type II accuracy. The reason why the particular indicators in [24] (the same as Altmans) were chosen are because they are frequently used as a normalizing factor (as in Altmans 1, 2, 3 and 5 indicators). Current assets can and will usually be converted into cash fairly fast. Finally, the rms sales are probably the least effective of Altmans ve indicators, because sales to total assets can vary a lot from industry to industry. The problem of bank failure prediction is considered in [31]. The study compares several methods: MDA, LR, K -nearest neighbour (KNN), a decision tree classication algorithm (ID3), single-layer network and multilayer network. The multilayer network was the best in the case of 1-year ahead predictions, while LR was proven to be the best in the case of 2-year ahead predictions. When they used a leave-one-out procedure instead of a hold-out sample, the clear winner was the multilayer network. KNN and ID3 were almost always inferior to the other methods. A comparative analysis of ANN models and their applications in bankruptcy prediction is discussed in [9].

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

Assessing corporate nancial health

541

The problem of bank failure prediction in Thailand is considered in [30]. The authors compared three neural networks: learning vector quantization, probabilistic neural network and feedforward network with back propagation learning. This study applied principal component analysis in order to reduce dimensionality. The data with dimensions of between 5 and 9 are the most efcient, while the data with dimensions of below 5 provided the lowest level of accuracy. Comparing these models, learning vector quantization outperforms the two other models, in terms of prediction accuracy and bias. Investigations into nancial distress predictions are characterized by a common adoption of discriminate and bivariate logit analysis in the research methodology. All of the models presented above have certain limitations and disadvantages that concern the denition of their dependent and independent variables, the reliability of the nancial information they use, and statistical and methodological limitations.

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

4 The conceptual model proposed by Chung for insolvency prediction

Research by Chung et al. [11] into insolvency prediction for the nancial industry in New Zealand has inspired this article. Their research uses a hybrid MDA model and ANN and presents an approach to model building and the conceptual model for insolvency prediction. Although the application of macroeconomic variables is proposed in the conceptual model, these variables were not used. This research reveals not only the great advantages of a hybrid MDA-ANN model of this type, but it also reveals certain shortcomings of the ANNs themselves. As with any system, ANN has its limitations [3]: (1) The learning stage can be very drawn out. (2) The system might not achieve a stable absolute minimum conguration, but could stay with local minimums without being able to move to the optimum conguration. (3) The system may begin to oscillate in the learning phase. (4) It is necessary to repeat the learning phase when signicant changes take place in the actual situation compared with the implicit situation in the training examples or when the set of examples is not representative of reality. (5) The analysis of the weightings is complex and difcult to interpret. There is little network transparency in the examination of the system logic, making it difcult to identify the causes of the errors/defective responses. The main problem of all neural network algorithms in general is that, they are rather unstable. Running the same algorithm, even using the same parameters; can lead to quite different results. Using the proposed conceptual model in research and aware of the aforementioned limitations of the ANN, we propose the use of the SOM rather than the ANN. Chungs conceptual model of insolvency prediction for corporate nance with our modications is presented in Figure 1. Furthermore, research has shown that the SOM yields better results than the ANN when the problem has fewer dimensions. The model proposes using Altmans Z -score as an input to the ANN which represents a 5D or 6D data set. SOM architecture has been determined as very efcient for such a small number of dimensions.

5 Empirical analysis
The objective of this study is the evaluation and the classication of the nancial health of a random sample of medium-sized and large companies in Serbia. In 2009, legal regulations allowed public

542 Assessing corporate nancial health

Input Financial Ratios MDA Self-Organising Maps - New ANN topology

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

Learning system Output Specific classifier: Solvent vs. Insolvent companies Knowledge Base

Input Macroeconomic variables

Not implemented

FIG. 1. Chungs conceptual model of insolvency prediction for corporate nance with our modications (in grey area).

access to the balance sheets of medium- and large-sized companies. However, the register does not include nancial reports for small companies, which is why the data sets only refer to medium-sized and large companies over the 2-year period (20082009) under study. The denition of corporate failure in this case study is a court ling by the rm under Chapter 7 or 11 of the US Bankruptcy Code. Both of these chapters are share the same meaning and signicance in Serbia as they do in the USA. Chapter 7 of the US Bankruptcy Code covers corporate liquidations, and Chapter 11 refers to corporate Reorganization (called Restructuring in Serbia), which usually occurs after a period of nancial distress. The unemployment rate in Serbia remains uncertain and no clear denition exists as yet. Frequent modications to legal regulations have led to changing denitions of unemployment categories (i.e. different denitions of unemployed status). Thus, the current situation is that the number of unemployed people seemingly remains unchanged, as does the number of employed people. Very large numbers of people are ofcially recorded as living without social security provision, training opportunities and assistance, although the ofcial statistics would rise steeply if everybodys details were held on record.

5.1 Data set development

Information made public in 2010 shows that, since 2004, the accounts of 10,400 companies have been blocked or the companies themselves have been declared insolvent or illiquid. However, these companies still manage to survive. In the present study, the corporate data consists of the nancial statements of 59 companies taken from the Serbian registry of companies. Most medium-sized and large companies in this random sample are solvent, although a smaller number are insolvent. Chapter 7 of the US bankruptcy code has been applied to seven companies, and Chapter 11 of the US bankruptcy code to three companies. This verication was possible only for companies with nancial reports over the period 20082009. Naturally, the register contains a much larger number of companies that are bankrupt, but for which no nancial records exist.

Assessing corporate nancial health

(a)
35 30 25 20 15 10 5 0 SAFE GREY DISTRESS 2008 2009

543

(b)
Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012
5,00 4,00 3,00 2,00 1,00 0,00 -1,00 -2,00 -3,00 SAFE GREY DISTRESS 2008 2009

FIG. 2. (a) Number of companies in the Safe, Grey and Distress zones. (b) Average Z -scores.

This study follows the method suggested in [22] to reduce the number of independent variables or nancial ratios that are summarized in Section 2.1. All the variables used in the Z -score model are included here. However, one of Altmans ratios (Equity market value to total debt) was not selected because of its inappropriate nature for the companies under observation.

5.2 Estimation of discriminant model

A gradual regression to develop an optimal MDA model was implemented. The overall t of the discriminant function involves three tasks: (i) calculating a discriminant Z -score for each observation; (ii) evaluating group differences in discriminant Z -scores; and (iii) assessing the accuracy of the prediction for group membership. Following the estimation of the discriminant model, the maximum Z -score values were 7.02 in 2008, and 6.89 in 2009 and the minimum Z -score values were 6.92 in 2008, and 8.04 in 2009. Figure 2a shows the number of companies in the three zones dened by Altman in [2]: the Safe zone, in which the Z -score is 3.00; the Grey zones, where the Z -score is 1.8 and 2.99; and the Distress zone where the Z -score 1.79. Figure 2b shows the average Z -score for each year.

5.3 Batch training algorithm

The nancial ratios and the discriminant Z -score that are used in MDA now become the input to the SOM. Then, the hybrid MDA-SOM model is used to predict corporate insolvency. The basic SOM procedure involves the following steps: (i) construct data setnancial ratios and discriminant Z -score; (ii) normalize data; (iii) train the map; (iv) visualize the map; and (v) analyse the results. The batch training algorithm is used in this process. Batch training algorithm is iterative, but instead of using one single data vector at a time, the whole data set is presented to the map before any adjustments are made. In each training step, the data set is partitioned according to the Voronoi regions of the map unit weight vectors. Each data vector belongs to its closest data set on the map unit. The new weight vectors are calculated as follows: wk (t + 1) =
n j =1 (v , k , t ) xj n j =1 ( v , k , t )

(2)

544 Assessing corporate nancial health The new weight vector is a weighted average of the data samples, in which the weight of each data sample is the neighbouring function value (v, k , t ) at its best matching unit (BMU) v. As in the sequential training algorithm, the missing value is simply ignored when calculating the weighted average. It is very important that the new weight vector is simply the average of the Voronoi data set in the batch version of the k -means algorithm. The above equation is as follows if (v, k , t ) = (v, k ). Alternatively, one can rst calculate the sum of the vectors in each Voronoi set:
nvi

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

si ( t ) =
j =1

xji

(3)

where, nvi is the number of samples in the Voronoi set of unit i. Then, the new values of the weight vectors may be calculated as follows:
m j =1 (v , k , t ) sj (t ) m j =1 nvj (v , k , t )

wk (t + 1) =

(4)

where, m is the number of map units. The batch algorithm is implemented in the following way in this study.

6 Experimental results
A SOM produces a low-dimensional, discretized representation of the input space of the training samples. This makes SOMs useful for visualizing low-dimensional views of high-dimensional data. The U-matrix shows distance between neighbouring units and thus visualizes the cluster structure of the map (Figure 3). Note that the U-matrix visualization has many more hexagons than the components. A high value on the U-matrix means a large distance between neighbouring mat units, and thus indicates cluster borders. Clusters are typically uniform areas of low values. A surface plot of the distance matrix appears below: both colour and z -coordinates indicate a denormalized average distance to neighbouring map units. Average distances in the distance matrix for nancial health based on corporate insolvency are shown in Figure 4. These are closely related to the U-matrix. The SOM is used for probability density estimation. Each map prototype is the centre of a Gaussian kernel, the parameters of which are estimated from the data. The Gaussian mixture model is estimated and the probabilities are calculated. The map grid is in the output space. Three components rst determine the 3D coordinates of the map unit, and the size of the marker is determined by the fourth component. All values have previously been denormalized. U matrix, Distance matrix, Prototype, Prototype and data for corporate nancial health for 2009 are presented in Figures 36. The results of this study correctly estimate corporate nancial health in Serbia for 95% of companies in 2008 and for 94% of companies in 2009. These corporate nancial health estimations are based on insolvency prediction supported by the hybrid MDA-SOM model. The result is comparable with studies in other countries: Del Rey (1996) 95% [27]; Crespo (2000) 9395% [14]. However, the results in this research are 7781% better than in [28].

Assessing corporate nancial health

545

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

FIG. 3. U-matrix for corporate nancial health in 2009.

FIG. 4. Distance matrix for corporate nancial health in 2009.

7 Conclusion and future development

A hybrid MDA and SOM model for insolvency prediction has been discussed in this article. Financial ratios and discriminant Z -scores that are used in MDA become the input to the SOM. Then, the hybrid MDA-SOM model is used to predict the corporate insolvency of companies in Serbia. The results of this research show correct estimates of the nancial health in 95% of all companies in the sample. Thus, the hybrid MDA-SOM yields very good results. This hybrid applied methodology is not overtly superior to other techniques, but the approach involves signicant advantages. The rst advantage would be the suitability of our research for the analysis of nancial ratios. Corporative nancial

546 Assessing corporate nancial health

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

FIG. 5. Prototype of corporate nancial health in 2009.

FIG. 6. Prototype and data of corporate nancial health in 2009.

ratios have signicant leverage over the use of a companys independent nancial values. Secondly, MDA can be used for the calculation of Altmans Z -score. This is very important because nancial ratios and Z -score results represent input values for the SOM. Furthermore, the implementation of the SOM in classication problems is a contemporary technique that represents the outcome of long-term ANN testing and implementation. It is possible to optimize parameters by considering a small number of parameters based on another algorithm. In addition to reducing the number of parameters for optimization, these methods have the potential to control several other properties such as weight distribution and connection topology [26]. All the above-mentioned characteristics represent the main technical and technological advantages of the model. Nevertheless, bearing in mind their contribution to the positive predictions obtained in this study, we should also pay attention to the business, economic and nancial reasons which are summarized below: (1) The model was discussed and tested in Serbia over a long transition period, from the start of 2000 up until 2010. (2) Long periods of economic transition produce high numbers of unemployed. This study has shown that companies that wish to keep up the pace of business development and remain solvent make between 10 and 20% of their employees redundant on an annual basis. Only 1 out

Assessing corporate nancial health

547

of all the 59 companies in the sample increased their workforce, the remainder reduced their personnel. (3) During the present global economic crisis, since 2008 to this day, large companies in Serbia have grown stronger or have retained their competitive advantage over medium-sized and small companies, and as a result, medium-sized and small companies have suffered greater damage. Large companies came out nancially and economically weaker yet they have survived, but large numbers of small and medium-sized companies are today illiquid, insolvent or bankrupt. (4) Furthermore, the 10 companies in this research that had recourse to Chapter 7 or 11 of the US bankruptcy code facilitated the classication of companies and had a signicant inuence on the results of this study. They all had large negative Z -scores in the Distress zone, leaving fewer companies to classify. This research is far from over and future developments as well as further research will continue in the area of corporate insolvency prediction models. The hybrid model proposed in this research improves the implementation of new algorithms and is a step towards new and advanced techniques for improving company solvency estimates. Further research into the different sectors, such as the agricultural sector and the agricultural product processing industry can, in the rst place, be very important for a country. Data from the 2010 corporate balance sheets, which will be published in February 2011, will open up new avenues for research into business activities, company behaviour and insolvency over longer periods of time.

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

References
[1] A. Abraham, E. Corchado, and J. M. Corchado. Hybrid learning machines. Neurocomputing, 72, 27292730, 2009. [2] E. Altman. Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23, 589609, 1968. [3] E. Altman. Corporate Financial Distress and Bankruptcy, 2nd edn. John Wiley & Sons, 1993. [4] S. C. Anderson. Investment Management and Mismanagement: History, Finding and Analysis. Springer, 2006. [5] D. Andres. Statistical techniques vs. SEE5 algorithm: an application to a small business environment. The International Journal of Digital Accounting Research, 2, 157184, 2001. [6] W. Beaver. Financial ratios as predictors of failure. Journal of Accounting Research, 4, 71111, 1966. [7] C. Bishop. Neural Networks in Pattern Recognition. Oxford University Press, 1995. [8] M. P. Blum. Failing company discriminant analysis. Journal of Accounting Research, 12, 125, 1974. [9] C. Charalambous, A. Charitou, and F. Kaourou. Comparative analysis of articial neural networks models: application in bankruptcy prediction. Annals of Operations Research, 99, 403425, 2000. [10] W. S. Chen and Y. K. Du. Using neural networks and data mining techniques for nancial distress prediction model. Expert Systems with Applications, 36, 40754086, 2009. [11] K. Chung, S. S. Tan, and D. K. Holdsworth. Insolvency prediction model using multivariate discriminant analysis and articial neural network for the nance industry in New Zealand. International Journal of Business and Management, 3, 1929, 2008. [12] E. Corchado, A. Abraham, and A. de Carvalho. Hybrid intelligent algorithms and applications. Information Science, 180, 26332634, 2010.

548 Assessing corporate nancial health Arroyo, and V. Tricio. Soft computing models to identify typical meteoro[13] E. Corchado, A. logical days. Logic Journal of the IGPL [Epub ahead of print; doi:10.1093/jigpal/jzq035; 21 July 2010]. [14] D. Crespo. Una aproximacion a la predici on del fracaso emperial mediante redes neuronales. In IX Encuentro de Profesores Universitarios de Contabilidad, Las Palmas de Gran Canaria, pp. 591607. Las Palmas de Gran Canaria, mayo de, 2000 [An approach to the failure prediction using neural networks IX Meeting of University Professors of Accounting, Las Palmas, Canary Islands, pp. 591607. Center for Financial Studies, May, 2000]. [15] E. B. Deakin. Business failure prediction: an empirical analysis. In Financial Crises: Institutions and Markets in a Fragile Environment, E. Altman and A. Sameti, eds. pp. 117138. John Wiley, 1977. [16] A. Dimitras, S. Zanakis, and C. Zapounidis. A survey of business failures with an emphasis on prediction models and industrial applications. European Journal of Operation Research, 90, 487513, 1996. [17] H. E. Frydman, E. Altman, and D. Kao. Introducing recursive partitioning for nancial classication: the case of nancial distress. Journal of Finance, 40, 269291, 1985. [18] A. Gonz ales, A. Correa, and J. A. Blaz aquez. Perl del fracaso empresarial para una muestra de Peque nas y Medianas Empresas. In XI Congreso de AECA, Madrid, 2001 [Prole of business failure for a sample of small and medium enterprises. In: XI AECA Congress Company, Euro and New Economy, Madrid, September, 2001]. [19] F. L. Jones. Current techniques in bankruptcy prediction. Journal of Accounting Literature, 6, pp. 131164, 1987. [20] T. Kohonen. Self-organised Maps, Vol. 30. Springer, 1995. [21] J. H. Legarreta, F. Boto, I. Mac a, J. Maiora, G. Garc a, C. Paloc, M. Gra na, and M. de Blas. Hybrid decision support system for endovascular aortic aneurysm repair follow-up. In Hybrid Articial Intelligent Systems. Vol. 6076 of Lecture Notes in Articial Intelligence pp. 500507. Springer, 2010. [22] M. Leshno and Y. Spector. Neural network prediction analysis: the bankruptcy case. Neurocomputing, 10, 125147, 1996. [23] L. Martinez. Forecasting company failure: an approach to Spanish insurance companies. Intelligent Systems in Accounting, Finance & Management, 5, 169185, 1996. [24] M. Odom and R. Sharda. A neural network model for bankruptcy prediction. In International Joint Conference Neural Networks. San Diego, CA, 1990. [25] J. Ohlson. Financial ratios and probabilistic prediction of bankruptcy. Journal of Accounting Research, 18, 109131, 1980. [26] A. A. Rad, M. Hasler, and M. Jalili. Reservoir optimisation in recurrent neural networks using properties Kronecker product. Logic Journal of the IGPL, 18, 670685, 2010. [27] E. D. Rey. Bankruptcy prediction in non-nance companies: an application based on articial models. Intelligent Systems in Accounting, Finance & Management, 5, 253272, 1996. [28] D. S. Sharma. The role of cash ow information and predicting corporate failure. Managerial Finance, 27, 328, 2001. [29] S. Simi c-Ivkov: Computer-assisted diagnosis of c, D. Simi c, P. Slankamenac, and M. Simi primary headaches. In Hybrid Articial Intelligent Systems. Vol. 5271 of Lecture Notes in Articial Intelligence, pp. 314321. Springer, 2008.

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012

Assessing corporate nancial health

549

[30] K. Sookhanaphibarn, P. Polsiri, W. Choensawat, and F. C. Lin. Application of neural networks to business bankruptcy analysis in Thailand. International Journal of Computational Intelligence Research, 3, 9196, 2007. [31] K. Tam. Neural networks models and the prediction for bank bankruptcy. Omega, 19, 429445, 1991. [32] F. Tohme `. Economic theory and alternative set theory AFA+ AD + DC. Logic Journal of the IGPL, 17, 179203, 2009. [33] P. A. Castillo, J. M. De la Torre, J. J. Merelo, and I. Rom an. Forecasting business failure. A comparison of neural networks and logistic regression for Spanish companies. In European Accounting Association 24th annual Congress, Athens, 2001. [34] A. Vellido, P. Lisboa, and J. Vaughan. Neural networks in business: a survey of applications (1992-1998). Expert Systems Applications, 17, 5170, 1999. [35] B. Wong, T. Bodnovich, and Y. Selvi. Neural networks in applications: a review and analysis of the literature (198895). Decision Support Systems, 19, 301320. 1997. [36] M. Wozniak and M. Zmyslony. Designing fusers on the basis of discriminants - evolutionary and neural methods of training. In Hybrid Articial Intelligent Systems. Vol. 6076 of Lecture Notes in Articial Intelligence, pp. 590597. Springer, 2010. [37] G. Zang, M. Hu, and B. Patuwo. Articial neural networks in bankruptcy prediction: general framework and cross-validation analysis. European Journal of Operation Research, 116, 1632, 1999. Received 4 November 2010

Downloaded from http://jigpal.oxfordjournals.org/ at Fundao Coordenao de Aperfeioamento de Pessoal de N-vel Superior on June 16, 2012