Applied Soft Computing Journal 83 (2019) 105663

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Applied Soft Computing Journal

journal homepage: www.elsevier.com/locate/asoc

A new perspective of performance comparison among machine

learning algorithms for financial distress prediction
∗
Yu-Pei Huang a,b , Meng-Feng Yen c ,
a
College of Management, National Cheng Kung University, Taiwan
b
Department of Electronic Engineering, National Quemoy University, No. 1, University Rd., Kinmen, County 892, Taiwan
c
Department of Accountancy and Institute of Finance, National Cheng Kung University, No. 1, University Rd., Tainan 701, Taiwan

highlights

• This paper reviewed the pros and cons of recent literature on various MLmodels for FDP.
• This paper compared the performance of six ML-based approaches using real-life data.
• Among the four supervised models, the XGBoost algorithm provided the most accurate FD prediction.
• The hybrid DBN-SVM model gave betterforecasts than both the SVM and the classifier DBN models.

article info a b s t r a c t

Article history: We set out in this study to review a vast amount of recent literature on machine learning (ML)
Received 14 March 2019 approaches to predicting financial distress (FD), including supervised, unsupervised and hybrid
Received in revised form 22 July 2019 supervised–unsupervised learning algorithms. Four supervised ML models including the traditional
Accepted 25 July 2019
support vector machine (SVM), recently developed hybrid associative memory with translation (HACT),
Available online 1 August 2019
hybrid GA-fuzzy clustering and extreme gradient boosting (XGBoost) were compared in prediction
JEL classification: performance to the unsupervised classifier deep belief network (DBN) and the hybrid DBN-SVM model,
G17 whereby a total of sixteen financial variables were selected from the financial statements of the
G32 publicly-listed Taiwanese firms as inputs to the six approaches. Our empirical findings, covering the
O16 2010–2016 sample period, demonstrated that among the four supervised algorithms, the XGBoost
O31 provided the most accurate FD prediction. Moreover, the hybrid DBN-SVM model was able to generate
Keywords: more accurate forecasts than the use of either the SVM or the classifier DBN in isolation.
HACT © 2019 Elsevier B.V. All rights reserved.
GA-fuzzy clustering
XGBoost
Hybrid DBN-SVM
Financial distress prediction

1. Introduction The prediction of the possibility of financial distress is clearly

When a firm is unable to continue to generate cash flows
from its business, maintain its profitability or meet its maturing
obligations as they fall due, it finds itself in a financial situation
usually referred to as financial distress; however, when many
firms simultaneously become mired in such financial distress, this
may bring about a severe financial crisis which can manifest itself
through serious social problems, such as economic recession and
rising unemployment. Thus, the global financial tsunami which
occurred in 2008 led to increasing attention being paid by finan-
cial institutions to credit risk and ‘financial distress prediction’
(FDP).
∗ Corresponding author.
E-mail addresses: tim@nqu.edu.tw (Y.-P. Huang), yenmf@mail.ncku.edu.tw
(M.-F. Yen).
a challenging task; however, it is generally believed that there
are many symptoms and alerts that can be observed prior to any
financial problems that firms may encounter. A firm’s basic fi-
nancial statements, which are the written records of the financial
situation of a business, include standard reports such as the state-
ment of financial position, statement of comprehensive income,
statement of cash flows and statement of changes in equity, all of
which provide a wide range of users with the information on the
results of the firm’s operations and its financial position, including
the cash flows of the business.
Conventional FDP methods
Since financial distress usually produces various signals, such
as a gradual or sudden significant reduction in profits, deferred

https://doi.org/10.1016/j.asoc.2019.105663
1568-4946/© 2019 Elsevier B.V. All rights reserved.
2 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663
payment of obligations (interest, preferred dividends and finan-
cial bills), and even bankruptcy, the information contained within
the financial statements can be used to establish diagnostic mod-
els of FDP [1]. However, since the traditional forms of assessment
of the credit risk of firms are invariably reliant upon the sub-
jective judgments of human experts – based upon their past
experience and some guiding principles – such assessments can
tend to be reactive rather than predictive. In particular, credit
scoring was not used until the late 1980s in the U.K. and the U.S.
and perhaps, for a few lenders, until in the late 1990s. Before
the introduction of credit scoring methods, a bank manager,
usually male, had to rely on his ‘‘gut feel’’, an assessment of the
prospective borrower’s character, ability to repay, and collateral
or security, and an independent reference from a community
leader or the applicant’s employer to reach a decision. This pro-
cess was slow and inconsistent [2]. Since the invention of credit
scoring system, moreover, ‘‘homegrown’’ scorecards may be so
informal or easily altered. Different users at a bank may input
the data and analyze the results using their own approaches to
achieving their desired outcome. Thus, the use of such approaches
when attempting to make consistent estimates may provide er-
roneous results [3]. Therefore, it is desirable to develop fairly
accurate quantitative prediction models using various internal
and external factors.
Numerous techniques have been developed over the years in
an attempt to provide analysts and decision-makers with effec-
tive methods of predicting financial distress based upon various
financial ratios and mathematical models, with these models
including linear and logistic regressions, multivariate adaptive
regression splines, survival analysis, linear and quadratic pro-
gramming and multiple-criteria programming [4–6]; for example,
Altman and Narayanan, suggested that when assessing the man-
agement of distressed firms, the Z-score model could be used
as a guide to financial turnaround [7]. Most of these techniques
are typically reliant upon the assumptions of linear separability
and multivariate normality, and indeed, the independence of the
explanatory variables [3]. However, these conditions are often
violated in real-life situations.
Machine learning
ML techniques have the capability of extracting meaningful
information from unstructured data whilst also effectively dealing
with non-linearity. However, the application of advanced ML
techniques to financial forecasting is still a relatively new area for
researchers to explore [8,9]. ML algorithms can be categorized in
to two major branches: supervised learning versus unsupervised.
Supervised learning
As regards the application of ML in the field of finance, su-
pervised methods such as Bayesian network algorithms, logistic
regressions and the support vector machine (SVM) are used to
detect financial misstatements with fraudulent intention [10].
Neural network (NN) models are also used as the means of de-
tecting earnings management [11,12]. Although NN architectures
have been found to demonstrate good performance in various
financial applications [1], the SVM is a better technique than
other classification and prediction methods since it produces
more accurate results than its competitors. This finding makes
SVM particularly suitable for FDP problems since the number of
financially-distressed firms is usually limited [13,14]. A recent
SVM-based hybrid model was proposed [15], in which the author
integrated a risk metric with a two-level data envelopment anal-
ysis (DEA) to describe the operating performance of a company.
The hybrid model was comprised of the rough set theory, artificial
fish swarm algorithm and fuzzy SVM. Basing on empirical evi-
dence, the hybrid model was effective at predicting the operating
performance for both public and private companies.
Cleofas-Sanchez et al. [3] applied Santiago-Montero’s hybrid
associative classifier with translation (HACT) model to predict
financial distress and provided empirical results supporting that
HACT dominated four traditional neural networks, including
multi-layer perceptron (MLP), radial basis function (RBF), Bayesian
network (BN), and voted perceptron (VP), one SVM and one
multi-variate logistic regression (LR) model. HACT was developed
from the traditional linear associative memory model (LAMM),
one of the artificial neural network models. It is characterized
to mimic the memorizing process of human kind via a series of
associative memory. The HACT boasts its two advantages over
the traditional LAMM. First, while the HACT model is also a
LAMM during the learning phase, it uses the Steinbuch Lernma-
trix method to enhance its prediction performance compared to
the LAMM during the recall phase. The LAMM can only take a
binary 0/1 value as its input. However, HACT accepts any type of
numerical, raw data as the feature vector for model input. Second,
the inputted vector does not need to meet the orthonormal
condition as required by the traditional LAMM. While the HACT
model is quick to train due to its feed-forward leaning frame-
work, however, it is only suitable for simple data with repetitive
structure. It would not be able to generate good learning and
prediction results for complicated data.
Chou et al. [16] proposed a hybrid structure integrating the
genetic algorithm (GA) with a fuzzy clustering algorithm. In par-
ticular, key financial ratios selected by the GA are clustered by the
fuzzy C-means clustering after the training data is divided into
financially distressed and financially non-distressed samples. The
optimal number of clusters for both samples are decided by the
WB index. Given the clustered training data, the distance between
the feature vectors of each cluster’s center and a testing sample
is calculated and used to predict whether the testing sample will
be an FD case according to the concept of ‘nearest neighbor’. For a
clustering method, it is important to ensure that selected features
are capable of correctly categorizing the samples into their corre-
sponding classes. The hybrid model integrates the advantages of
both statistical theory and soft computing by using the genetic
algorithm to select features in order to make the clusters of
features meaningful for the subsequent data classifier. However,
the major drawbacks of this method are the high possibility of
overfitting the training data as well as the time consumed to find
the optimal results.
Zięba et al. [17] proposed using extreme gradient boosting
(XGBoost) to learn an ensemble of decision trees for bankruptcy
prediction. Their so-called synthetic feature is comprised of var-
ious arithmetic operations such as addition, subtraction, mul-
tiplication, and division. Each synthetic feature can be treated
as a regression model and constructed in an evolutionary way.
They used the model to predict the financial condition of Polish
companies spanning the 2000–2013 period and found it able to
generate prediction results significantly better than quite a few
reference models such as linear discriminant analysis, multilayer
perceptron with a hidden layer, decision rules inducer, decision
tree model, LR, AdaBoost, SVM and random forest. Xia et al. [18]
employed the XGBoost to structure a sequential ensemble credit
scoring model, whereby they tuned the hyperparameters using a
Bayesian optimization algorithm with a selected feature subset.
Their empirical results showed that the Bayesian optimization
performed better than random search, grid search, and manual
search. The credit scoring results were interpreted by a decision
tree using the relative importance among selected features, which
was ranked in a descending order. Carmona et al. [19] used
the XGBoost to predict bankruptcy basing on 156 national U.S.
 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663
commercial banks spanning the 2001–2015 period. A total of 30
financial ratios were collected on an annual basis. They found
that the ratio of retained earnings over average equity, pretax
ROA and total risk-based capital ratio were negatively associated
with the probability of bank failure. In contrast to the three ratios
above, exceptionally high return on earning assets brought about
higher risk of failure for the bank. In parallel with the study above,
the same technique was applied by Climent et al. [20] to predict
financial distress for the commercial banks in the Eurozone using
25 yearly financial ratios spanning the 2006–2016 period. They
found that the two-year-before-failure model performed better
than its one-year and three-year counterparts. In addition, the
size of bank (measured by total assets) and the non-operating
income over net income ratio were positively associated with the
risk of bank failure, while leverage (measured by equity divided
by liabilities) and asset liquidity were negatively associated with
the risk of bank failure.
Antunes et al. [21] proposed a probabilistic Gaussian processes
(GP) classifier which is less sensitive to the class balance relative
to SVMs and LRs. It provided a comparable performance to imbal-
anced and balanced datasets. Basing on an entropy-based analysis
for real-world bankruptcy data, the GP classifier was capable of
tackling uncertainly and providing better prediction than SVMs
LRs.
Wang and Wu [22] proposed a two-stage ensemble model,
which integrated a manifold learning algorithm with a kernel-
based fuzzy self-organizing map (KFSOM) to predict bankruptcy.
The model employs three manifold learning algorithms, Isomap,
Laplacian Eigenmaps and Locally Linear Embedding, to select a
feature subset, respectively. These algorithms are good at reduc-
ing the dimension of input data for any data distribution. Three
base classifiers were constructed by the kernel-based fuzzy self-
organizing map (KFSOM) using three kernel functions, Gaussian,
Polynomial and Sigmoid. A total of 9 classifiers, 3 feature subsets
vs. 3 KFSOMs, were then integrated by the two-stage selective en-
semble algorithm. According to different criteria, the 9 classifiers
were integrated based on a stepwise forward selection method
in the first stage. In the second stage, three selective classifiers
were further integrated to bring about the final prediction results.
KFSOM can improve fuzzy self-organizing map (FSOM) which is
subject to the limitation of spherical data distribution. Financial
data is usually very complicated so that the requirement for
spherical data distribution by traditional FSOM cannot be satis-
fied. Wang and Wu [22] used kernel-based methods to map the
original data to high-dimensional feature space without a specific
mapping rule and conduct the non-linear transformation, which
facilitated the classification or clustering for the transformed data.
Garcia et al. [23] employed four linear classifiers, Fisher’s
linear discriminant, linear discriminant classifier, SVM and LR, to
predict corporate bankruptcy basing on the dissimilarity space in-
stead of the traditional feature space. Their empirical results sug-
gested that the four classifiers tended to provide better prediction
when applied onto the dissimilarity space than the feature space
in terms of overall accuracy, true-positive rate and true-negative
rate.
Masmoudi et al. [24] reported that, basing on two classes
of bank-loan data, the default prediction performance of their
discrete BN model was comparable to SVM but better than the
decision tree approach. Including the latent variable in the BN
enhanced the classification results. Their model is useful in iden-
tifying the relatively important loan characteristics which affect
the default probability. Therefore, the model is informative for
management of non-performing loans. In addition, this type of
models are quick and easy to train.
3
Unsupervised learning
Traditional ML algorithms need to extract certain features
from the data, such as the moving average of a time series on
the price of a stock; however, it is invariably found to be quite
difficult to systematically extract these features or to obtain all
of the representable factors. Deep learning (DL) has emerged as
a new area of ML research since 2006, as it is found to be very
effective in terms of learning the data characteristics [25,26]. The
‘Deep belief network’ (DBN) introduced by Hinton and Salakhut-
dinov [27] is a generative neural network model and works well
for dimensionality reduction and feature extraction.
Principal component analysis (PCA) is another unsupervised
technique which is mainly used to learn linear combinations of
all original variables which best fit the distribution of the training
samples. Stated otherwise, PCA aims to find a lower-dimensional
region in the input space in which the training data have a
higher probabilistic density. However, real-world data manifolds
are usually complex and highly non-linear [28]. DBNs are thus a
better choice in modeling highly non-linear data with complexity.
The entropy-based evaluation method, Information Gain, is
characterized by complicated mathematical theories and formu-
las about entropy. A classification is made by maximizing the
amount of information that a certain feature can provide, which
is obtained based on the difference value of the feature’s en-
tropy. All features with trivial information gain are deleted while
preserved features are ranked in a descending order according
to their information gain. As a result, Information Gain is able
to reduce the dimensionality of vector space model by setting
the threshold. However, the problem is that it is very difficult to
choose a proper threshold [29]. Using the unsupervised DBNs to
select important features has the following advantages relative to
PCA and Information Gain. First, in contrast to PCA, DBNs are able
to characterize complex, non-linear data. Second, the capability
of discovering important features by DBNs in an unsupervised
manner makes them less prone to the problem of overfitting
than models such as feedforward neural networks [30]. Finally,
classifier DBNs provide classification performance comparable to
SVMs but better other techniques like Maximum Entropy and
Boosting-based classifiers [30].
Hybrid supervised–unsupervised learning
While SVM is effective at producing decision surfaces from
well-behaved feature vectors, it is time-consuming when tack-
ling a large, high-dimensional dataset. Although SVM can be
used to reduce high dimensionality of features, moreover, impor-
tant information might be lost during dimensionality reduction.
Therefore, an unsupervised deep learning technique, DBN, was
proposed since it was able to reduce the feature dimensionality if
given enough hidden layers. The DBN model is capable of learning
more profound features and capturing rich information hidden
in the data [31]. The features obtained are substantially more
representative than the original data, and thus the DBN model
is more suitable for classification and visualization problem [25].
Yu et al. [31] proposed a DBN based resampling SVM ensemble
learning paradigm to solve imbalanced data problem in credit
classification. Through integration with a resampling SVM, the
DBN model served as a competitive ensemble strategy, capable of
improving the performance of classification, especially for highly
imbalanced datasets. The invented revenue matrix basing on the
principle redeemed (from non-failure borrowers) and interest
collected (from failure borrowers) was very relevant to the real-
world scenarios. In the circumstance of real-world setting, the
weights or costs of different class are presumed to differ from
each other significantly, and a certain class should attract more
4 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663
attention than the other. Basing on genuine German and Japanese
credit datasets, the cost-sensitive hybrid SVM-DBN structure was
effective at classifying credit risk for imbalanced data.
A hybrid DBN-SVM method was verified by Zhu et al. [32]
that it could be utilized to accurately recognize emotion status
in speech, in which DBN acted as a deep feature extractor and
SVM was a classifier. Combining them could achieve a better
result than that of using only DBN or SVM in isolation. Their
empirical results showed that DBN features can reflect emotion
status better than artificial features, and the hybrid DBN-SVM
classification approach achieved a high accuracy of 95.8%, which
was higher than using either DBN or SVM separately. In sum-
mary, coupling a DBN with an SVM is advantageous since the
former addresses the complexity and scalability issues of the
SVM, especially when training with large-scale datasets [28]. The
experimental results by [28] showed that the hybrid DBN-SVM
model yielded comparable anomaly detection performance with
a deep autoencoder, while reducing its training and testing time
by a factor of 3 and 1000, respectively.
Advantages and disadvantages of recent ML-based FDP methods
Following the literature review on the recent development of
ML-based FDP methods, we highlight he advantages and disad-
vantages of them in Table 1 below.
Having surveyed a vast amount of literature on financial dis-
tress (bankruptcy) prediction models, we would like to mention
a recent reference by Barboza et al. [9] who compared the per-
formance of four types of ML models against three types of
traditional approaches in terms of one-year-before-failure predic-
tion. The four ML families were SVMs, bagging, boosting and RF,
whilst the three kinds of traditional methods involved discrim-
inant analysis, LR, and NNs. Basing on 10,000 firm-year obser-
vations of Altman’s Z-score as well as Carton and Hofer’s [38]
six financial variables for North American firms spanning the
1985–2013 period, ML models were found to provide better pre-
diction results than traditional approaches. On average, Barboza
et al. [9] found ML models to be about 10% more accurate than
the traditional approaches (71% to 87% versus 52% to 77% in terms
of accuracy ratio). The six financial variables were composed of
operating margin, change in ROE, change in P/B ratio, growth
measures related to assets, sales and number of employees, which
improved all models’ prediction performance obtained by using
the Z-score alone. Among ML models, however, SVM did not bring
about better prediction results than its competitors, a finding
contradicting Cleofas-Sánchez et al. [3] but supporting Wang
et al. [39] among others. In particular, RF performed best among
all models.
Intended Contribution
Given the disparity in FDP performance among supervised
and unsupervised ML methods reviewed above, we aimed in this
study to provide a new perspective of the relative FDP perfor-
mance between the two types of ML techniques. In particular, we
used five recently developed methods as well as the traditional
SVM to predict financial distress basing on the financial data on
public-listed companies in Taiwan. Four of the six models above
fell into the supervised family: SVM, HACT, hybrid GA-fuzzy clus-
tering, XGBoost. One fell into the unsupervised family: classifier
DBN. The last one fell into the hybrid supervised–unsupervised
family: hybrid DBN-SVM. We implemented the hybrid DBN-SVM
algorithm mainly to test whether the unsupervised feature ex-
tractor can enhance the traditional supervised approach. The rest
of the paper is organized as follows. Section 2 documents the data
and machine learning techniques used in this study. Section 3
discusses the empirical results while Section 4 concludes.
2. Methodology
2.1. Financial distress variables
Firms are required to provide formal records of their financial
activities in the form of financial statements; thus, all publicly-
listed enterprises are required to generate four basic financial
statements, as shown below:
a. Statement of financial position — statement of financial
position at a given date.
b. Statement of Comprehensive Income — reporting financial
performance in terms of net profit or loss over a specific
period.
c. Statement of Changes in Equity — reporting any movement
in the owner’s equity over a specific period.
d. Statement of Cash Flows — summarizing the movement in
cash and bank balances over a specific period.
These four basic financial statements provide information on
the results of the firms’ operations, financial position and cash
flows.
In order to establish the diagnosis model for financial distress
prediction, we selected 16 financial variables recommended in
numerous prior related works and extracted from the state-
ments in this study [40–48]. We then constructed the proposed
diagnosis model using the financial data provided by the Tai-
wan Economic Journal (TEJ). The selected variables and their
definitions are shown in Table 2.
The TEJ database highlighted a total of 32 firms which had
encountered a period of financial distress between 2010 and
2016. Each of these distressed firms was then matched with a
non-distressed firm from the same industry in the same event
year. The total assets of the non-distressed counterpart firm were
required to be the most approximate to the distressed sample
from all of the competitor firms in the same industry in the same
event year, resulting in a total of 32 financially-distressed and 32
non-distressed firms in our 2010–2016 sample period. The firms
were categorized as financially-distressed if they were either in
bankruptcy or in the process of recovery.
We collected and analyzed financial statement data on these
firms for one to four quarters prior to any financial distress event,
with seven combinations of the latest four quarterly financial
datasets then being used to evaluate the proposed model; that
is, 1Q, 2Q, 3Q, 4Q, 1Q∼2Q, 1Q∼3Q and 1Q∼4Q. These financial
data are obtained from at least one set of quarterly financial
statements.
As illustrated in Fig. 1, our 64 sample firms were located in 16
different industry categories, of which the major industries were
optoelectronic materials, semiconductors and electronic compo-
nents.
The breakdown of the industries is summarized in Table 3,
while Table 4 shows that the total assets of the firms examined
in this study ranged from ‘smaller than NT$ 1 billion’ to ‘larger
than NT$ 10 billion’, with about 47 per cent of the firms falling
within the NT$ 1 billion to 10 billion range. The results reported in
Table 5 reveal that the average total asset value of the distressed
firms was around NT$ 25 billion, whilst the average for the
non-distressed firms was around NT$ 29 billion.
2.2. Construction of FDP models
Fig. 2 illustrates how we used the three types of ML algorithms
to perform FDP prediction. In particular, the four supervised ML
algorithms consist of SVM, HACT, hybrid GA-fuzzy clustering and

Table 1
Advantages and disadvantages of ML-based FDP models.
Supervised learning
Support Vector Machine (SVM)
[13,14,31]
Hybrid Associative Classifier with
Translation (HACT) [3]
Hybrid genetic algorithm (GA) and
fuzzy clustering [16]
eXtreme Gradient Boosting
(XGBoost) [17–20]
Probabilistic Gaussian processes (GP)
classifier [21]
Random Forest (RF) [9,32–35]
Two-stage selective ensemble
model [22]
Linear classifiers [23]
Discrete Bayesian network
(BN) [24,36]
Unsupervised learning
Classifier Deep Belief Network
(DBN) [29–31,37]
Hybrid supervised–unsupervised
method
Hybrid DBN-SVM [28,31,37]
XGBoost, while the unsupervised ML algorithm refers to the clas-
sifier DBN and the hybrid supervised–unsupervised ML algorithm
refers to the hybrid DBN-SVM model. All six models were used
Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663
Advantages
SVM is capable of eliminating massive redundancy, and
thus has superiority in low algorithmic complexity and
high robustness. SVM can reduce the possibility of
overfitting by setting the parameter of cost function,
which is a significant problem in credit risk evaluation.
Relative to other supervised learning algorithms, SVM
has proved to show good generalization performance.
HACT is a kind of feed-forward neural network. The
model is very fast to train since it does not involve any
back-propagation framework.
The hybrid model integrates the advantages of both
statistical theory and soft computing by using the
genetic algorithm to select features in order to make
the clusters of features meaningful for the subsequent
data classifier. The hybrid model proved to provide
better performance than the BPNN classifier in
predicting bankruptcy.
The supervised learning algorithm integrates gradient
descent and tree ensemble learning, which can be used
for regression and classification problems. The model is
regarded as one of the best supervised learners which is
fast to train and supported by various packages and
platforms.
The probabilistic GP classifier is less sensitive to the
class balance compared to SVM and LR. It provides a
comparable performance to both imbalanced and
balanced datasets.
Noisy data or outliers are allowed in the training
dataset in an RF model. RF does not only classify data
but also provide information for the driving
determinants of classification among groups because the
model is able to identify the importance of each
variable in the classification results.
The manifold learning algorithms are good at reducing
the dimension of input data for any data distribution.
The original data can be mapped into a
high-dimensional feature space by the kernel-based
FSOM method to cluster original data, which relaxes the
limitation of the spherical distribution for the data in
traditional FSOM. The stepwise forward selection
method in the first stage of this two-stage ensemble
model is easy to understand and implement, and can
strengthen the model’s performance effectively.
The four linear classifiers, Fisher’s linear discriminant,
linear discriminant classifier, SVM and LR, are good at
handling sparse data, easy to describe mathematically.
In addition, they are computationally simple and easy to
interpret. When applied to data of dissimilarity, they
are able to provide satisfactory performance.
BNs are one of the most consistent and general
specifications for modeling complicated systems. The
model is useful in identifying the relatively important
loan characteristics which affect the default probability.
Advantages
Given sufficient hidden layers, the model is good at
learning features. In particular, it can identify more
profound features and uncover rich information hidden
in the data.
Advantages
Since it is difficulty for SVM to classify large datasets
with high dimensionality, using the before-mentioned
DBN to reduce the dimensionality of features for SVM
classifier is advantageous.
to distinguish whether a firm was financially distressed (FD) or
financially non-distressed (FND).
5
Disadvantages
The model tends to be computationally demanding for
large-scale data. Moreover, it is not able to generate
satisfactory classification results for the ‘small’ class in
imbalanced data. Re-sampling methods can help
overcome these drawbacks. Although SVM can be used
to reduce high dimensionality of features, it might
cause loss of important information.
It is only suitable for learning simple and repetitive
data. It is not able to generate satisfactory results for
complicated data.
The model is computationally demanding, in particular,
for large-scale data. High possibility of overfitting might
be another problem.
It has a large and complex set of hyperparameters
which are not easy to be tuned. Relative to DL
algorithms, it does not tend to perform well when
handling non-structural features such as images and
voices.
Like SVM, the final performance behavior of this
kernel-based model is sensitive to parameter selection.
RF usually does not perform as well in regression
problems as in classification because it cannot produce
continuous outputs. For regression problems, RF is not
able to generate predictions outside the range of the
training data, indicating high possibility of overfitting
when the training data contain noise.
The model’s effectiveness is only examined by using
Chinese listed companies. The financial data of other
countries should be included to validate the model.
They are not applicable for non-linearly distributed data.
Although the Bayesian formalism is useful in modeling
the knowledge of experts, it is difficult to define the
conditional probability table out of experts’ opinion due
to the difficulty to reach agreement on the BN model
with experts.
Disadvantages
Finding the optimal parameterization for the model is
complicated and time demanding.
Disadvantages
Finding the optimal parameterization for the DBN part
of the hybrid model is complicated and time demanding.
6 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663

Fig. 1. Breakdown of the 64 companies investigated, by industry.

Table 2 The financial data on the FD and FND firms were retrieved
Selected financial variables for financial distress prediction. from the four basic financial statements which are readily avail-
Variables Definitions References able from the TEJ database. We calculated the 16 variables which
V1 Current ratio [16,17,21,22,40–42] were regarded within the extant literature as having the greatest
V2 Cash flow/total debt [22,40–42]
relevance to financial distress. This set of 16 financial ratios on
V3 Cash flow/total asset [40,43,44]
V4 Cash flow/sales [40,43,45] all firms was then divided into validation and training sets for
V5 Debt ratio [16,40,44,46] prediction accuracy evaluation.
V6 Working capital/total asset [9,17,21,40,47,48]
V7 Market value equity/total debt [40,42,45] 2.3. Supervised prediction models
V8 Current asset/total asset [40,43]
V9 Quick asset/total asset [40,43]
V10 Sales/total asset [9,40,45,48] The four supervised ML algorithms are specified as follows.
V11 Current debt/sales [40,43]
V12 Quick asset/sales [40,43] 2.3.1. SVM
V13 Working capital/sales [40,42,44]
V14 Net income/total asset [40,41,44]
The SVM is a supervised ML technique, originally introduced
V15 Retained earnings/total asset [9,17,40,46,48] by Cortes and Vapnik [49], which has since become a standard
V16 Earnings before interest and taxes/total asset [40,45,48] classification technique in many classification problems. When
the SVM is exploited as a binary classifier, it constructs a hy-
Table 3
perplane which separates two classes by training data with a
Summary of the industry categories of the companies investigated. maximal margin by quadratic optimization method [50]. The SVM
Industry categories No. Industry categories No. model of this study was constructed with the training dataset
Accommodation 2 Metallic furniture 4
{xi , yi }(i = 1, 2, . . . , n; yi ∈ {−1, +1}), where xi was the input
Air transport 2 Optoelectronic materials 14 financial data vector; yi = 1 was defined as an output belonging
Basic metals 6 Raw material medicines 2 to the FD class, and yi = −1 was set as an output in the FND class;
Computers 2 Semi-conductors 8 n was the size of the training dataset. In addition, to avoid the
Construction 2 Software 4
Consumer electronics 2 Telecommunications equipment 2
dominance of financial data of greater numerical variation over
Electronic components 8 Textiles 2 those of relatively smaller variation, all features of the training
Materials recovery 2 Wearing apparel 2 data were scaled to the range [−1, +1].
The aim of training an SVM is to find a maximum-margin
hyperplane ω · xi + b = 0 to separate yi = 1 from yi = −1, where
Table 4
Total assets of the candidate firms. ω represents the weight vector of the separating hyperplane, and
Total assets (NT$) Number of firms % b represents the offset. It is usually difficult to linearly separate
<1 billion 24 38
financial data points. As a result, a ‘radial basis function’ (RBF)
1∼10 billion 30 47 kernel function k(xi , xj ) was adopted in this research to map
>10 billion 10 16 the training data vector xi onto a higher-dimensional feature
space vector Φ (xi ) for separation. All the parameters of the SVM
Table 5
model were tuned in order to obtain the optimal maximal-margin
Summary statistics on the total assets of the candidate firms. hyperplane for classification.
Total assets (NT$) Distressed Non-Distressed
Average (billion) 25.83 29.11 2.3.2. Hybrid associative classifier with translation (HACT)
Max. (billion) 722.86 612.37 Following Cleofas-Sánchez et al. [3], in the learning phase of
Min. (billion) 0.03 0.26 HACT, all features (financial ratios) of the training data needed
Median (billion) 0.88 2.7 to be normalized, in which the mean of a feature is subtracted
No. of firms 32 32
from its original value. The feature vector and classification label
of the 48 out of the 64 samples were used for training a linear
associative memory model which would learn and memorize the
patterns of the data above. In the recall phase (i.e. prediction
 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663 7

Fig. 2. Data processing flow of the three types of ML FDP algorithms.

Fig. 3. Algorithm of HACT.

phase) of HACT, we normalized each feature of the testing dataset
by subtracting the mean of all 48 samples of the training dataset
from the feature’s value of the testing dataset. The 16 normalized
samples of the testing dataset were then used to produce FDP. We
cross-validated the prediction accuracy by performing the experi-
ment above four times, each corresponding to a non-overlapping
testing dataset of 16 samples. Fig. 3 illustrates the algorithm of
HACT.
2.3.3. Hybrid GA-fuzzy clustering
Figs. 4 and 5 below illustrate Chou et al.’s [16] algorithm in the
context of this study. The genetic algorithm was used to select
the optimal set of features in which the number of genes of each
chromosome was equal to the number of data features (financial
ratios). If the value of a gene was equal to 1 (0), the corresponding
feature would (not) be selected. We set the maximum number
of generations equal to 100, each with 200 chromosomes. Only
10 chromosomes with the highest fitness values were kept for
the next generation. We used the uniform crossover and set the
mutation rate equal to 0.1. An early stop would apply when
the best fitness value could not be further elevated within any
10 consecutive generations. To evaluate the feature selection
outcome (fitness) of a chromosome, we reserved a random 30%
of the training samples. In particular, the 70% of the training
8 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663
Fig. 4. Algorithm of hybrid GA-fuzzy clustering.
samples were used to construct the model, while the remaining
30% of them were reserved to evaluate the FDP accuracy (i.e. the
fitness of the chromosome). When constructing the model, we
applied the fuzzy C-mean clustering to the FD samples and FND
samples, respectively, using the Silhouette index to determine the
optimal cluster number. Note that we replaced Chou et al.’s [16]
WB index by the commonly-adopted Silhouette index since the
WB index was proposed by a non-published reference which is
not available.
2.3.4. XGBoost
XGBoost is a supervised learning which can be used for re-
gression and classification problems. The concept of XGBoost
combines gradient descent and tree ensemble learning. Through
additive training, one new tree is added at a time to the previous
XGBoost model to improve on its prediction performance and
optimize the value of a pre-specified objective function. There is a
total of 5 hyperparameters for an XGBoost model: learning rate,
maximum depth, subsampling percentage for samples, subsam-
pling percentage for features, and maximum number of iterations.
To achieve best prediction performance, we selected the optimal
set of hyperparameters using a 4-fold cross-validation. In line
with the hybrid GA-fuzzy clustering algorithm, we needed to
normalize each feature of the training samples to the range [0,
1]. In particular,
xtrain − min(xtrain )
xˆ
train = (1)
max(xtrain ) − min(xtrain )
 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663
Fig. 5. The feature selection process of the hybrid GA-fuzzy clustering algorithm.
The original range of each feature of the training samples was
then used to normalize the testing samples as follows.
xtest − min(xtrain )
xˆ
test =
max(xtrain ) − min(xtrain )
If any normalized feature of the testing sample fell outside the [0,
1] range, however, we would renormalize it back the [0, 1] range.
As regards the hyperparameters, we set the learning rate equal
to 0.1, the maximum depth 5, 7, 9, 10, and 11, respectively,
the subsampling percentage for samples 0.5, 0.7, and 0.9, re-
spectively, the subsampling percentage for features 0.5, 0.7, and
0.9, respectively, amounting to a total of 45 combinations. The
maximum number of iterations was set equal to 2000. When
the loss function of the evaluation dataset could not be further
reduced within any 20 consecutive iterations, the training was
immediately terminated. We used a 4-fold cross-validation to
obtain the optimal set of hyperparameters. Given the optimal
hyperparameters, we used all 48 samples of the training dataset
to construct the model which was then used to predict FD for
the testing dataset. Fig. 6 illustrates the algorithm of the XGBoost
model.
9
2.4. Unsupervised prediction model (DBN)
DBN is one of the unsupervised ML algorithms attracting most
attention. The model is comprised of multiple layers of stacked
(2)
‘restricted Boltzmann machines’ (RBM). RBM is a stochastic gen-
erative neural network with symmetric weighted connections
(w) between the visible and hidden layers, but there are no
connections between the neurons within a layer. As illustrated
in Fig. 7, there are two layers of neurons in a RBM, which are the
visible layer with neurons (vi ) and the hidden layer with latent
neurons (hj ).
An autoencoder DBN is a powerful model for feature extrac-
tion applications [27]. As illustrated in Fig. 8, an autoencoder
DBN is constructed by stacking RBMs on top of each other. In
this study, the visible neurons of the RBM#1 take real values
because the calculated financial ratios are all continuous data, as
opposed to the hidden neurons with stochastic binary values. The
DBN model is trained from bottom to top layers; for instance,
the RBM#1 is trained first, and the activation probabilities of the
neurons of its hidden layer (h1 ) then become the input data of
the visible layer (v2 ) for the RBM#2 learning. All the RBMs of a
DBN are sequentially trained in the aforementioned manner, and
finally the activation values of the hidden neurons of the top RBM
10 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663

Fig. 6. The algorithm of XGBoost.

are returned as extracted features. The extracted feature vector

of the top RBM is more useful for classification than the original
input data. This layer-by-layer learning can be repeated as many
times as desired to find the best feature-extracting DBN.
The efficient training method for RBMs proposed by Hinton
is called contrastive divergence (CD), which provides an approxi-
mation to the maximum likelihood method to adjust the weights
and biases between the visible and hidden neurons. The learning
process of the CD algorithm is illustrated in Fig. 9. The CD method
starts with a ‘‘learning’’ procedure, which uses RBMs as a tool
to extract the features of the input data. After that, a ‘‘recon-
struction’’ procedure learns features from the extracted feature,
and therefore the reconstructed vectors can be used to compare
with the original data for weights and biases training. A higher
probability of the joint configuration of the visible vectors (vi ) and Fig. 7. An example of RBM.

hidden vectors (hj ) can be trained by adjusting the corresponding

weights and biases to obtain a lower energy function value [51].
However, a DBN can also be used as a classifier, the primary
a classifier DBN, it is necessary to include a discriminative RBM
aim of which was to obtain labels from the input data, namely,
distressed or non-distressed in the context of this study. For such in the last layer for classification.
 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663
Fig. 8. An autoencoder DBN with four stacked RBMs [27].
Fig. 9. The learning process of the contrastive divergence algorithm.
2.5. Hybrid supervised–unsupervised prediction model (DBN-SVM)
In addition to the supervised and unsupervised ML algorithms,
we also examined a recently introduced hybrid FDP model which
integrated the advantages of both supervised and unsupervised
ML algorithms [52]. In particular, we used an autoencoder DBN
to extract features from financial ratios. Each visible neuron of
the first layer represented a financial ratio, while each hidden
neuron of the last RBM represented a feature after the train-
ing was completed. Given that the data were pre-trained using
the autoencoder DBN network, the extracted features were then
classified using the SVM. In this study, the number of features
extracted by the autoencoder DBN was set equal to 3. As a result,
the 16 financial ratios of each firm were transformed into three
features which were then used as input data for the SVM. We
employed the same parameter specifications for the classifier
DBN (including the same numbers of input and hidden layers)
to carry out the model training in the previous unsupervised
11
FDP model. Having experimented with a number of different
frameworks, a five-layer DBN with three hidden layers of 200,
100 and 50 neurons, along with three features at the output layer,
was found to provide the best performance in this study.
2.6. Training and validation of the models
The DBN was implemented in the object-oriented Deep Learn-
ing Toolbox v1.2 in MATLAB. All of the code and experiments
were carried out using MATLAB 2016a. The Parallel Computing
ToolboxTM and a CUDA⃝ R
-enabled NVIDIA⃝ R
GPU were also used
in order to accelerate DBN training. In contrast, the SVM was
implemented using the MATLAB Toolbox, with the ‘svmtrain’
method being used for training and the ‘svmclassify’ method
for classification. As regards the algorithms and experiments for
HACT, hybrid GA-fuzzy clustering and XGBoost, they were all
programmed and implemented using MATLAB 2016a.
As illustrated in Fig. 2, data on the 16 financial ratios for both
FD and FND samples were divided into validation and training
sets for prediction accuracy evaluation. In order to make the most
of the available data and achieve an average level of classifi-
cation accuracy, we employed a variant of the ‘leave-one-out’
cross-validation approach, since the cross-validation procedure
is capable of circumventing the problem of over-fitting. In par-
ticular, in each experiment, the data belonging to each class
(distressed or non-distressed) were randomly divided into four
sub-sets, with each of these four sub-sets containing 25 per cent
of the data in any given class. In each cross-validation, one data
sub-set was selected as a test set, with the remaining sub-sets
forming the training set. We carried out cross-validation four
times, and then subsequently measured the average classification
accuracy of the classifier. We also took into consideration the
different time spans of the prior financial data in the study to
identify whether prediction performance was dependent upon
how many quarterly financial statements were used.
3. Empirical results
3.1. Classification results
The evaluation results reported in Table 6 revealed that, among
all algorithms, XGBoost provided the most accurate FD prediction.
Among the unsupervised and hybrid learning algorithms, on the
other hand, the hybrid DBN-SVM generated the most accurate FD
prediction. In general, SVM, XGBoost, classifier DBN, and hybrid
DBN-SVM models produced better prediction using consecutive
quarterly financial ratios (1Q∼2Q, 1Q∼3Q, 1Q∼4Q) than using
one single quarterly financial ratio. For HACT and hybrid GA-fuzzy
clustering, the difference in prediction performance between the
use of consecutive quarterly data and the use of one single
quarterly data was economically trivial.
In addition, the hybrid DBN-SVM model was capable of gen-
erating more accurate forecasts of financial distress, as compared
to the use of either the SVM or the classifier DBN algorithm in
isolation. Furthermore, the results also showed that the informa-
tion contained in a consecutive series of quarterly data provided
all three approaches with better forecasting accuracy than basic
quarterly data.
Turning to the best FD predictor, XGBoost, Table 7 summarized
its prediction performance using various spans of quarterly data
prior to the event quarter. Basing on the results contained by
Table 7, the best prediction rate was generated by using either
the 1Q∼2Q or 1Q∼4Q dataset. In both scenarios, the type I error
was as low as 3.1% and the type II error was only 6.3%.
The prediction performance of the hybrid DBN-SVM model
using different combinations of prior quarterly financial data was
12 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663

Table 6
Comparisons of model prediction accuracy across different spans of quarterly data prior to each event quarter.
Prediction accuracy (%)
Learning types Models
1Q 2Q 3Q 4Q 1Q∼2Q 1Q∼3Q 1Q∼4Q
SVM 73.4 70.3 67.2 62.5 82.8 79.2 81.3
Supervised ML learning HACT 67.2 56.3 53.1 64.1 64.1 57.8 56.3
GA-Fuzzy 43.8 35.9 39.1 37.5 39.1 39.1 40.6
XGBoost 87.5 89.1 84.4 82.8 90.6 87.5 90.6
Unsupervised ML learning Classifier DBN 53.1 68.8 51.6 65.6 68.0 69.8 71.9
Hybrid supervised–unsupervised ML Learning DBN-SVM 79.7 75.0 70.3 71.9 89.1 82.3 86.3

Table 7
The prediction performance of the XGBoost model using different spans of
quarterly data prior to each event quarter.
Prediction accuracy (%)
Variables
1Q 2Q 3Q 4Q 1Q∼2Q 1Q∼3Q 1Q∼4Q
Type I error 4.7 4.7 9.4 10.9 3.1 3.1 3.1
Type II error 7.8 6.3 6.3 6.3 6.3 9.4 6.3
True positive rate 84.4 87.5 87.5 87.5 87.5 81.3 87.5
True negative rate 90.6 90.6 81.3 78.1 93.8 93.8 93.8
Prediction accuracy 87.5 89.1 84.4 82.8 90.6 87.5 90.6

Note:
Type I error (%) = FP /(TP + FN + FP + TN), Type II error(%) = FN /(TP + FN +
FP + TN),
True positive rate (%) = TP /(TP + FN), True negative rate (%) = TN /(FP + TN),
Accuracy (%) = (TP + TN)/(TP + FN + FP + TN);
Abbreviation: FP: false positives, FN: false negatives, TP: true positives, TN: true
negatives.

Table 8 Fig. 10. Feature extraction result for the DBN (1Q∼2Q).
The prediction performance of the hybrid DBN-SVM model using different spans
of quarterly data prior to each event quarter.
Prediction accuracy (%)
Variables
1Q 2Q 3Q 4Q 1Q∼2Q 1Q∼3Q 1Q∼4Q
Type I error 12.5 10.9 15.6 15.6 4.7 13.0 7.0
Type II error 7.8 14.1 14.1 12.5 6.3 5.2 6.6
True positive rate 84.4 71.9 71.9 75.0 87.5 89.6 86.7
True negative rate 75.0 78.1 68.8 68.8 90.6 74.0 85.9
Prediction accuracy 79.7 75.0 70.3 71.9 89.1 81.8 86.3

summarized in Table 8, where the results clearly indicated that

the use of multiple quarterly data produced greater accuracy
(>80 per cent), as compared to the use of basic quarterly data.
Consistent with the results observed for feature extraction, the
highest prediction accuracy was found to be obtained by using
the previous two consecutive quarters of financial data. We found
that the prediction accuracy was around 89 per cent, with a
type I error of 4.7 per cent and a type II error of 6.2 per cent. Fig. 11. Separation of distressed and non-distressed firms (1Q∼2Q).
However, our results also indicated that the use of longer-period
consecutive quarterly data might not necessarily lead to better
prediction accuracy.
roughly separating the financially-distressed (FD) and financially
3.2. Feature extraction of the hybrid DBN-SVM model non-distressed (FND) classes. The features were produced by a
16-200-100-50-3 DBN which mapped the input financial data
In the hybrid model, the data on the 16 selected financial onto three features, where 16, 200, 100, 50 and 3 referred to the
variables were pre-trained using a DBN network which extracted number of hidden neurons of the input layer, the three hidden
the features from the input data. The features were extracted by layers and the output layer, respectively. As a result, the DBN
the DBN, layer by layer, with the hidden-neuron activation values mapped the input data (16 features) onto three features.
then being returned into the output layer as extracted features. The data extracted from the DBN were subsequently classified
The empirical results showed that using these extracted fea- by the SVM, with the results illustrated in Fig. 11 being based
tures did improve the financial distress prediction performance
upon the two consecutive quarters of data prior to the occurrence
relative to using the original input data for SVM. The highest
of any financial distress event. The financially distressed and non-
prediction accuracy was obtained by using the previous two
consecutive quarters (1Q∼2Q) of financial data prior to any fi- distressed classes were successfully separated by the hyperplane,
nancial distress event. The DBN feature-extraction results using with the highest accuracy level being provided by the previous
the two consecutive quarters of data were illustrated in Fig. 10. two consecutive quarters of financial data, as clearly illustrated
As shown in Fig. 10, the three extracted features were capable of in Fig. 11.
 Y.-P. Huang and M.-F. Yen / Applied Soft Computing Journal 83 (2019) 105663
4. Conclusions
A series of financial distress by large companies might cause
a chain reaction such as the 2008 financial crisis. If the firm
management, the lenders or stockholders are not able to foresee
such a crisis, chances are the result will damage their interests
to a significant extent in the end. However, traditional credit
risk assessment approaches are inconsistent across various users
and the assessment result highly depends upon their desired
outcome. As a result, accurate quantitative methods are necessary
in providing an objective and consistent estimates of the risk
of financial failure. We set out in this study to compare the
performance of six machine-learning approaches in the context of
financial-distress prediction. By referring to the extant literature,
we summarized sixteen financial ratios, calculated from the four
basic financial statements of publicly-listed firms in the Taiwan
stock market which are regarded as being related to future finan-
cial distress. The data on these financial ratios were subsequently
used as input data for six classification algorithms, traditional
SVM, HACT, hybrid GA-fuzzy clustering, XGBoost, classifier DBN
and hybrid DBN-SVM, to predict financial distress. Our empir-
ical results appeared to suggest that among all four types of
supervised approaches, the XGBoost model produced the most
accurate prediction performance. In addition, we demonstrated
that the hybrid model comprising of the DBN feature extractor
and the SVM – within which the data were pre-trained using
the DBN algorithm and then classified using the SVM algorithm
– was capable of predicting the financial distress of a firm to a
satisfactory extent. The latent features were extracted from the
ratios calculated from the financial statement data using the DBN.
Our results showed the users of financial statements the fea-
sibility of using financial statement data to construct an effective
FDP model. Indeed, XGBoost and the use of deep learning tech-
nique to augment supervised ML approaches have shown promise
in this research area. The main contributions of and values added
by this study are as follows. First, it summarized the advan-
tages and limitations of recent literature on different supervised,
unsupervised, and hybrid supervised–unsupervised models for fi-
nancial distress prediction. Second, it compared the performance
of six ML-based approaches in the context of financial distress
prediction using real-life data. Third, it suggested that among
the four supervised algorithms, the recently popular XGBoost
algorithm provided the most accurate FD prediction. Finally, it
verified that the hybrid DBN-SVM model was able to generate
more accurate forecasts than the use of either the SVM or the
classifier DBN in isolation. Future research is encouraged to ex-
amine if the feature extracting function of a DBN can be used to
further improve on the latest supervised ML approaches such as
the XGBoost for financial distress prediction.
There is, however, one specific limitation that is worth noting.
In line with the prior studies, we constructed the FDP model
based upon the quarterly data of the 16 selected variables; future
studies may succeed in improving prediction accuracy further
by using different sets of financial variables sampled at different
time frequencies, such as data on monthly revenue or daily stock
prices.
Declaration of competing interest
No author associated with this paper has disclosed any po-
tential or pertinent conflicts which may be perceived to have
impending conflict with this work. For full disclosure statements
refer to https://doi.org/10.1016/j.asoc.2019.105663.
13
Acknowledgments
The corresponding author is grateful to the Center for Inno-
vative FinTech Business Models, National Cheng Kung University,
Taiwan (ROC) for a research grant to support this work. We would
like to thank the Reviewers for their valuable comments and
suggestions, which have helped to improve the quality of this
paper substantially.
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