Knowledge-Based Systems 57 (2014) 41–56

Contents lists available at ScienceDirect

Knowledge-Based Systems
journal homepage: www.elsevier.com/locate/knosys

Predicting financial distress and corporate failure: A review

from the state-of-the-art definitions, modeling, sampling, and featuring
approaches
Jie Sun ⇑, Hui Li, Qing-Hua Huang, Kai-Yu He
School of Economics and Management, Zhejiang Normal University, Jinhua, Zhejiang 321004, PR China

a r t i c l e i n f o a b s t r a c t

Article history: As a hot topic, financial distress prediction (FDP), or called as corporate failure prediction, bankruptcy
Received 13 April 2012 prediction, acts as an important role in decision-making of various areas, including: accounting, finance,
Received in revised form 6 December 2013 business, and engineering. Since academic research on FDP has gone on for nearly eighty years, there are
Accepted 6 December 2013
abundant literatures on this topic, which may appear chaotic to the researchers of the field and make
Available online 13 December 2013
them feel confused. This paper contributes to the current review researches by making a full summary,
analysis and evaluation on the current literatures of FDP. The current literatures of FDP are reviewed from
Keywords:
the following four unique aspects: definition of financial distress in the new century, FDP modeling, sam-
Definition of financial distress
Sampling methods
pling approaches for FDP, and featuring approaches for FDP. By considering the new state-of-the-art tech-
Featuring methods niques in this area, FDP modeling are classified and reviewed by the following groups: namely, modeling
Review with pure single classifier, modeling with hybrid single classifier, modeling by ensemble techniques,
Financial distress prediction dynamic FDP modeling, and modeling with group decision-making techniques. Sampling methods for
Corporate failure prediction FDP are classified and reviewed by the following paired groups, namely: training sampling and testing
Case-based reasoning sampling, single industry sampling and cross-industry sampling, balanced sampling and imbalanced
Ensemble sampling. Featuring methods for FDP are categorized and reviewed by qualitative selection and combi-
Group decision-making
nation of qualitative and quantitative selection. We comment on the current researches from the view
Support vector machine
of each category and propose further research topics. The review paper is valuable to guide research
Hybrid modeling
Neural network and application of the area.
Decision tree Ó 2013 Elsevier B.V. All rights reserved.
Logistic regression
Multiple discriminant analysis

1. Introduction making for investors, credit decision-making for creditors, cus-

The word of ‘‘Early Warning’’ is originated from military area.
Nowadays, the word is widely used in some respects such as: mac-
roeconomics, business administration, environmental monitoring,
among others. Early warning of financial distress, corporate failure,
or bankruptcy is an important research field for corporate finance
and its core is financial distress prediction (FDP), which is an
extensive ongoing research topic. Generally, FDP is to predict
whether or not a company will fall into financial distress based
on the current financial data, through mathematical, statistical,
or intelligent models. It is also called as financial failure discrimi-
nation, bankruptcy prediction, business failure prediction, corpo-
rate failure prediction, among others. It plays an important role
on managerial decision-making for firms, investment decision-
⇑ Corresponding author. Tel.: +86 579 8229 8567.
E-mail address: sunjiehit@gmail.com (J. Sun).
tomer credit rating for banks, and so on.
During the last fifty years, numerous researches focus on this
topic and attempt to provide a useful solution for the problem. Lit-
eratures on this topic may appear chaotic to the researchers of the
field and make them feel confused. A thoughtful review on related
articles is useful to help people understand the research and devel-
opment in FDP. Thus, this paper attempts to review the state-of-
the-art researches from a new perspective, which is different from
the several review articles on FDP in recent years. Balcaen and
Ooghe [11] extensively elaborated on the application of classical
statistical techniques in FDP from the following categories,
namely: single variable analysis, risk index models, multivariate
discriminant analysis (MDA), and conditional probability models.
This review made a contribution to the current literature by clari-
fying the characteristics of the classical statistical techniques in
FDP and their related problems. However, intelligent techniques
are more frequently used in FDP than statistical techniques in re-
cent years. Thus, Kumar and Ravi [58] considered both statistical

0950-7051/$ - see front matter Ó 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.knosys.2013.12.006
42 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
and intelligent techniques in FDP, and classified articles of FDP
from the following groups, namely: statistical techniques, neural
networks (NN), case-based reasoning (CBR), decision trees (DT),
operational research, evolutionary algorithms (EA), rough set (RS)
based techniques, other techniques, and soft computing techniques
from the hybridization of all the above-mentioned techniques.
They also reviewed each article on the source of data, financial
variables, country, time line of the data, and performance of tech-
niques. This review presented that the hybrid modeling is a hot to-
pic in FDP. By considering researches in this category,
Bahrammirzaee [10] conducted a comparative review of three fa-
mous intelligent techniques for financial applications, i.e., artificial
neural networks, expert systems and hybrid intelligent systems.
Credit evaluation and financial prediction are two chief problems
for financial market. They concluded that these intelligent methods
were superior to traditional statistical ones in dealing with finan-
cial problems, although such superiority is not absolute. Verikas
et al. [125] presented a comprehensive review of hybrid and
ensemble-based soft computing techniques for FDP. Their focus
was on how different techniques were combined. A technique
was named as hybrid if several soft computing approaches were
applied and only one predictor was used to make the final predic-
tion. A technique was called as ensemble if outputs of several pre-
dictors were combined to obtain a prediction. Lin et al. [74] made a
review of FDP literatures between 1995 and 2010. They carried out
statistical analysis on the FDP literatures in terms of single and soft
classifiers, baseline classifiers, and datasets, and considered soft
classification techniques as the direction for future research of
FDP. Marques et al. [78] summarized the application of evolution
computing to credit scoring, which included classification, variable
selection, and parameter optimization. They also reviewed perfor-
mance evaluation criteria, statistical significance tests, credit dat-
abases, and some data preprocessing issues.
Though the six reviews have been published, this review is
valuable and significant for the following reasons:
(1) From the above six review articles we can find that hybrid
intelligent techniques are potentially useful models for FDP
with high predictive performance. Thus, how to construct
hybrid models for FDP needs to be analyzed by grouping
the current work.
(2) Meanwhile, with the development of computing and model-
ing techniques, some new techniques may also be useful for
solving the problem of FDP, e.g., dynamic prediction of finan-
cial distress, class imbalance classification techniques, fea-
ture selection approaches, group decision-making
techniques, among others. How these new emerged tech-
niques can be used in FDP needs to be analyzed by summa-
rizing existing researches.
(3) Third, none of the existing review articles provides a clear
indication on FDP with different sampling techniques and
feature selection approaches. This topic needs to be
investigated.
(4) Fourth, some review articles in the last century discussed
the definition of financial distress, which was seldom
focused on in recent reviews. However, the definition of
financial distress should be re-considered since some new
concept or phenomena come into the area of FDP in the
new century. The current reviews need some supplement
to help researchers understand the area of FDP more
thoughtfully.
This review is to fetch up the gap of the current reviews. We re-
viewed the current FDP literatures from the following four unique
aspects: definition of financial distress in the new century, FDP
modeling, sampling methods for FDP, and featuring approaches
for FDP. In detail, FDP modeling articles are classified and reviewed
by the following groups: namely, modeling with pure single classi-
fier, modeling with hybrid single classifier, modeling by ensemble
techniques, dynamic FDP modeling, and modeling with decision
implementations. Sampling methods for FDP are classified and re-
viewed by the following paired groups, namely: training sampling
and testing sampling, cross-industry sampling and single industry
sampling, balanced sampling and imbalanced sampling. Feature
selection methods for FDP are categorized and reviewed by quali-
tative selection and quantitative selection.
This paper is organized as follows. Section 2 overviews and
comments on the definition of financial distress in the new cen-
tury. Section 3 reviews and comments on FDP modeling methods
from the category of pure single classifier methods, hybrid single
classifier methods, ensemble methods, dynamic modeling for
FDP, and FDP-based decision implementations. Section 4 reviews
and comments on sampling methods for FDP. Section 5 presents
the overview and comments from the perspective of featuring
methods for FDP. Section 6 concludes and analyzes some further
research topics in FDP.
2. Development of definition of financial distress in the new
century
2.1. Development of definition of financial distress
Financial distress is the situation that an enterprise has certain
kind of financial difficulties. In some classical literatures, such
financial difficulties include inability to pay debts or preferred div-
idend and the corresponding consequences such as overdraft of
bank deposits, liquidation for interests of creditors, and even enter-
ing the statutory bankruptcy proceeding [13,3,29]. Such definition
of financial distress is based on the theoretical framework of ‘‘cash
flow’’ or ‘‘liquid assets’’ model. As Beaver [13] mentioned, an enter-
prise is like a reservoir formed by the cash flow, composed of cash
inflows and outflows. An enterprise in financial distress is just like
a reservoir whose water is drained.
Carminchael [18] believed that financial difficulty is a situation
that an enterprise encounters frustration in fulfilling its obliga-
tions. These frustrations include: insufficiency of liquidity, insuffi-
ciency of equity, default of debt, and insufficiency of liquid capital.
Foster [35] defined financial distress as a serious liquidity problem
which is unable to be resolved without large-scale restructuring of
the operation or structure of economic entities. In Doumpos and
Zopounidis [32], financial distress not only contains inability to re-
pay important obligatory payments and the corresponding conse-
quences mentioned above, but also includes the situation of
negative net asset value, which means an enterprise’s total liabili-
ties exceed its total assets from the view of accounting.
Ross et al. [100] summarized previous studies and concluded
that financial difficulties consist of the following four conditions:
(1) business failure, that is, a company cannot pay the outstanding
debt after liquidation; (2) legal bankruptcy, namely, a company or
its creditors applies to the court for a declaration of bankruptcy; (3)
technical bankruptcy, namely, a company cannot fulfill the con-
tract on schedule to repay principal and interest; and (4) account-
ing bankruptcy, namely: a company’s book net assets are negative.
In the 21st century, most FDP literatures that collect data from
developed countries or areas concentrate on the prediction of
bankruptcy, which is the ultimate and most serious form of finan-
cial distress [76,106,89,22]. Bose [14] defined financial distress as
the condition that a company’s stock price is less than 10 cents,
which is followed by Ravisankar et al. [96]. When studying FDP
for Taiwan companies, Lin [72] defined financial distress as the
inability of a firm to pay its financial obligations as they mature.
 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
Operationally, a firm is said to have been failed when any of the
following events have occurred: bankruptcy, bond default, an over-
draft of bank account, events signifying an inability to pay debts as
they come due, entrance into a bankruptcy proceeding, an explicit
agreement with creditors to reduce debts, or being classified as
‘‘full delivery stock’’ by Taiwan Stock Exchange or Gre Tai Securi-
ties Market.
While in developing countries like mainland of China and Iran,
financial distress is usually defined as certain degree of financial
deterioration ruled by the national security management institu-
tion. For example, Chinese listed company’s financial distress is de-
fined as special treatment (ST) by Chinese Stock Exchange for the
reason that their profits continue to be negative for two consecu-
tive years or their per-share net assets are lower than per-share
stock face value [109,31,110]. The Iranian companies whose re-
tained losses are more than 50% of their capital are labeled as
financial distress according to commercial law of 141 act of Tehran
Stock Exchange [93]. In addition, Sun et al. [108] proposed the con-
cept of relative financial distress, which is defined as relative dete-
rioration of financial situation for a certain enterprise with the
process of its life cycle.
2.2. Comments on definition of financial distress
Above all, for definition of financial distress, there exist many
different points of view. Different scholars may give different
explanations according to their own study purpose. Broadly speak-
ing, there are two main ideas:
From the perspective of theoretical analysis, financial distress
has different degrees. Mild financial distress may just be temporary
cash flow difficulty, while serious financial distress is business fail-
ure or bankruptcy. An enterprise in financial distress may experi-
ence a dynamic changing process of various states between the
above two extreme forms of financial distress. Actually, financial
distress is a dynamic ongoing process, and is the result of continu-
ous abnormality of business operation for a period of time (from
months to years or even longer).
From the perspective of empirical research, in order to make
clear the criteria of research sampling, or for the restrictions of data
availability, financial distress is often defined as some situations
which clearly show an enterprise’s financial difficulty, such as stat-
utory bankruptcy, and ST for Chinese listed companies. Current
studies considered single criteria of financial distress rather than
the intensity of it, and future studies need to explore a metric that
can classify the distressed companies into different degrees such as
mild, intermediate, and bankrupt.
3. Review on FDP modeling methods
FDP is the core process of financial distress early warning. Its re-
search progress can be briefly summarized as follows: from single
variable analysis to multivariate prediction; from traditional statis-
tical methods to machine learning methods based on artificial
intelligence; from pure single classifier methods to hybrid single
classifier methods and classifier ensemble methods; from station-
ary modeling to dynamic modeling considering time process; from
quantitative prediction methods to decision implementations.
3.1. Pure single classifier methods for FDP
3.1.1. Statistical single classifier methods
Statistical single classifier methods, including the single vari-
able analysis, the MDA, and the Logit model, are based on statisti-
cal theory. Such statistical methods of FDP are usually simple,
easy-to-use and time-saving.
43
The single variable analysis is the earliest method for FDP. As
the most famous research on this FDP method, Beaver [13] pro-
posed two single variable analysis methods, namely the profile
analysis and the univariate discriminant model. By the profile anal-
ysis for five years before failure, he found that the means of finan-
cial ratios in two groups were significantly different, and the nearer
to the failure time, the more obvious the gap was. Afterward, he
respectively used five financial ratios as independent variables to
build univariate discriminant models and concluded that the more
recent date from the failure, the lower misjudgment rate and the
stronger predictability. The FDP methods based on single variable
analysis only use one financial ratio at each time. When different
ratios are used to make FDP for the same company, it will cause
a conflict for different conclusions.
Altman [3] firstly used the MDA for FDP that belongs to multi-
variate prediction. He constructed the famous Z-score model that
is a multivariate linear discriminant function with five financial ra-
tios, and found that its predictive power at the year before bank-
ruptcy was significantly better than the single variable
discriminant model. The MDA belongs to linear regression analysis,
which assumes that independent variables should obey multivari-
ate normal distribution and equal covariance matrixes. When sam-
ple data do not meet these two assumptions, the results of a MDA
model may be suspicious. In addition, the dependent variable for
the MDA is assumed to be a continuous one, which disaccords with
the fact that the probability of an enterprise falling into financial
distress only values in [0, 1].
The Logit linear probability model uses the logistic function to
transform the dependent variable of financial distress probability
into a totally continuous one that is then suitable for linear regres-
sion analysis. Ohlson [85] firstly applied the Logit model to de-
scribe the relationship between financial situation and financial
ratios and suggested that the Logit model was more rational than
the MDA model for the application of FDP. Zavgren [134] used fac-
tor analysis to obtain the independent variables for the Logit model
of FDP. Recently, Tseng and Lin [123] proposed a quadratic interval
Logit model for FDP by using a quadratic programming approach to
deal with binary response variables in the logistic regression. The
results indicated that the new Logit model improved the discrimi-
nate performance of FDP and provided more information to
researchers. On one hand, the Logit model is applicable to FDP
for its non-continuous dependent variable expressed as financial
distress probability. On the other hand, the Logit model is not
based on the assumptions that independent variables should fol-
low normal distribution and equal covariance. However, it still re-
quires that the independent variables have no linear functional
relationship with each other, namely, no multi-collinearity
problem.
Recently, Serrano-Cinca and Gutiérrez-Nieto [105] applied par-
tial least square discriminant analysis (PLS-DA) to predicting the
2008–2011 USA banking crisis, and found that results resembled
linear MDA and SVM results. PLS-DA has the advantage that it is
not affected by multicollinearity. Some studies attempted to inte-
grate the MDA and the Logit model with some other techniques
by hybrid or ensemble. These literatures are reviewed in the Sec-
tions 3.2 and 3.3. For a detailed understanding of FDP with statis-
tical techniques, please refer to Balcaen and Ooghe [11].
3.1.2. Artificial intelligence single classifier methods
Artificial intelligence single classifier methods for FDP include
NN, EA, RS, CBR, SVM, etc. They are applied to FDP on the basis
of the fruitful research results of computer and artificial intelli-
gence technology. They are not subject to the stringent assump-
tions required for statistical methods.
44 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
3.1.2.1. Neural networks. In early 1990s, NN began to be introduced
into the research on FDP, e.g., Tam [118], Tam and Kiang [119]. A
NN model consists of an interconnected group of artificial neurons,
and processes information using a connectionist approach for com-
putation. A wealth of related researches studied on NN methods for
FDP, and the most widely used is the three-layer feed-forward
back-propagation NN (BPNN), in which the hidden layer deter-
mines the mapping relationships between input and output layers
and the relationships between neurons are stored as weights of the
connecting links [84,23,72]. The probabilistic NN was also widely
used for FDP and it employs Bayesian decision-making theory
based on an estimate of the probability density in data space
[132,129]. The FDP performances of NN models were often com-
pared with those of the MDA and Logit models, and most re-
searches provided evidence for the conclusion that NN performed
better than the statistical methods [34,17,60,135,89,71,129,93].
The advantages of NN over the statistical methods are often attrib-
uted to its strong mapping ability based on the network structure.
In addition, the statistical relations among variables need not to be
considered in the process of NN model construction. Such an
advantage of NN is supported by the conclusion of Lin [72] that
indicates NN can achieve higher prediction accuracy if the data
does not satisfy the assumptions of the statistical approaches. In
addition, Chen and Du [23] found that BPNN also performs better
than data mining clustering technology for the purpose of FDP.
However, compared to statistical methods, far more sample
data are needed to train a relatively stable NN model, and too
much duplication of training easily leads to over-fitting, which de-
creases the stability of cross-sample prediction. In addition, NN is
often criticized by practitioners for its difficulty of understanding
because the complex network structure seems to be a black-box
for the decision makers. To overcome this drawback, Baesens
et al. [9] captured the learned knowledge embedded in the net-
works and expressed it as explanatory rules and a decision table
that facilitates easy consultation. Setiono et al. [104] proposed a
novel approach to train minimal NNs that are easy to generate con-
cise and comprehensible classification rules for the user. Such a re-
search direction for NN-based FDP is very important because it
makes NN-based models easier to be applied for the real-world
FDP problem.
3.1.2.2. Support vector machines. Support vector machine (SVM) is a
relatively new artificial intelligence method that is based on the
structural risk minimization principle rather than the empirical risk
minimization principle. SVM is a powerful and promising data clas-
sification and function estimation tool [130], which is not easy to run
into over-fitting even for relatively small sample. Shin et al. [107]
and Min and Lee [80] both used SVM to predict bankruptcy for South
Korean companies, and drew the conclusion that this method out-
performed MDA, Logit and NN. Hui and Sun [49] and Ding et al.
[31] respectively adopted SVM model to do empirical study on
FDP for Chinese listed companies, and reached a similar conclusion.
Li and Sun [68] used a straightforward wrapper approach to help
SVM model produce more accurate prediction of business failure,
which effectively improve efficiency of SVM in FDP. Gesel et al.
[39] demonstrated that least square SVM was the most preferred
predictive model for FDP compared with the Logit, the Fisher MDA
and the quadratic MDA. Their results also indicated that bankruptcy
problems were weakly non-linear. However, Bose and Pal [15] com-
pared the performance of SVM in FDP with those of MDA and NN,
and concluded that SVM performed worse than NN. More studies
used SVM with some other techniques in a hybrid or ensemble
means, instead of independent use of SVM. These literatures are re-
viewed in Sections 3.2 and 3.3.
3.1.2.3. Evolution algorithms. EAs are generic population-based
meta-heuristic optimization algorithms that use mechanisms in-
spired by biological evolution, such as reproduction, mutation,
recombination, and selection. Varetto [124] applied Genetic Algo-
rithm (GA) to extract linear functions without statistical restric-
tions and their corresponding discriminant rules. However, its
FDP performance was not as good as MDA. Shin and Lee [106]
adopted GA to search split point (threshold) of financial ratios,
and then extracted the quantitative discriminant rules of bank-
ruptcy prediction. Kim and Han [55] used GA to mine experts’
qualitative bankruptcy prediction rules that had the advantages
of easy understanding. However, such rules-based methods could
generate FDP results for companies only when at least one rule is
activated, and the coverage rate of rules were relatively low. In
addition, Rafiei et al. [93] also found that GA had lower FDP accu-
racy than NN. Etemadi et al. [33] investigated the application of
Genetic Programming (GP) for bankruptcy prediction for Iranian
listed firms, and McNemar test showed that GP outperformed
MDA. Some other EAs, e.g., Particle Swarm Optimization, Ant Col-
ony Optimization, are potential alternatives for FDP. For example,
Martens et al. [75] developed AntMiner + based on Ant Colony
Optimization to produce reasoning rules for FDP, but this tool
was inferior to SVM in term of predictive accuracy. Hence, the
FDP methods based on EAs can generate rules that are more inter-
pretable than NN or SVM models, but the performance based on
EAs alone is limited and they are more suitable to be combined
with other classification algorithms for FDP.
3.1.2.4. Case-based reasoning. FDP based on CBR generally uses K-
nearest neighbor algorithm, which determines or predicts the tar-
get cases’ labels according to similar cases’ labels. The evident
advantage of CBR is that it is easy to understand and its prediction
accuracy is also relatively high with the development of CBR tech-
nique. By comparing CBR, NN and MDA, Jo and Han [52], Jo and
Han [53] found that there was no real difference between CBR
and MDA, and CBR performed well when data was not sufficient.
Park and Han [87] applied AHP weighted K-nearest neighbor algo-
rithm to bankruptcy prediction, and significantly improved the
prediction accuracy by integration of qualitative and quantitative
indicators. Sun and Hui [109] proposed a similarity weighted vot-
ing CBR method based on gray correlation distance, which per-
formed effective short-term FDP one or two years in advance. In
recent years, Li and Sun [62], Li and Sun [63], Li and Sun [64], Li
et al. [61] respectively injected principles of ELECTRE, PROMETHEE,
ORESTE, and TOPSIS methods into CBR to generate various CBR
methods with reasonable FDP performances. Borrajo et al. [16]
constructed a multi-agent system for business control process
and failure prediction, and the core agent incorporates a CBR
system.
3.1.2.5. Rough set. Dimitras et al. [30] and McKee [76] respectively
applied RS theory to establish bankruptcy prediction model on
Greece data and US data. They found that this method had many
advantages, e.g. easily understandable decision rules in natural
language, case support for decision rules, combination of qualita-
tive and quantitative variables, no statistical evaluation of the
probability and fuzzy membership, etc. However, different samples
and decision-makers’ knowledge would generate different set of
decision rules. Bose [14] also applied RS to decide financial health
of dot-coms with an acceptable validation accuracy of 72.08%, but
RS often resulted in many rules associated with each class and
most of them (90%) were redundant. Therefore, RS has the short-
comings of unfixed structure and poor universality.
 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
3.1.2.6. Decision tree including RSP, CART and See 5.0. Frydman et al.
[36] and McKee and Greenstein [77] adopted recursive partitioning
(RSP) method which created DTs for FDP. Sun and Li [111,112] pro-
posed a data mining method based on attribute induction, infor-
mation gain, and DT, and applied it for FDP of Chinese listed
companies. Gepp et al. [38], Li et al. [65] also proved that DT or
classification and regression tree (CART) or See 5.0 had better
FDP performance than MDA. Chen [24] empirically compared DT
with Logit for Taiwan firms, and found that DT got higher accuracy
than Logit in short run (less than one year), while Logit performed
better in long run (above one and half year). Olson et al. [86] found
C5 and CART DT obtained better FDP performances than NN and
SVM for the particular US bankruptcy data set, but DT models were
easy to generate too many rules. They controlled this by adjust-
ment of minimum support parameter, which helped make a trade-
off between average accuracy and DT size.
3.1.2.7. Other techniques. Besides the above major FDP methods,
there are some other ones. For example, Sarkar and Sriram [103],
Gesel et al. [40], Sun and Shenoy [116], and Wu [127] applied
Bayesian (kernel) classifier for early warning of business failures.
Pendharkar [88], Cielen et al. [27], and Premachandra et al. [92]
used data envelopment analysis as a tool for corporate failure pre-
diction. Kwak et al. [59] proposed a multiple criteria linear pro-
gramming (MCLP) method for FDP with Korean data, and
indicated that the MCLP performed as well as MDA and Logit and
was comparable to DT and SVM. Ryu and Yue [102] developed a
new mathematical programming model named Isotonic Separation
(IS) for FDP, which outperformed MDA, NN, DT, and RS in the bank-
ruptcy prediction experiment with North American data. IS is dif-
ferent from the well-known statistical survival analysis methods
in that it is able to predict a sample’s survival time frame [101].
Chandrasekaran et al. [20] further revised IS to make it applicable
on regression problems.
3.1.3. Comments on pure single classifier methods for FDP
Pure single classifier methods are the base for FDP modeling
and each one has its own superiority and inferiority. Statistical
methods are restricted by statistical assumptions, but they can ob-
tain a fixed model structure in different times of training on a cer-
tain data set. On the contrary, artificial intelligence methods are
not subjected to statistical assumptions and can construct FDP
models for more complex data context, but their training processes
are much more complex too. Table 1 shows the comparison of
training characteristics among six typical artificial intelligence
classification algorithms. Firstly, CBR does not need training pro-
cess before implementation of FDP, which greatly differs from
the other five algorithms that need training models/rules before
FDP. Secondly, DT has an advantage that it needs not setting any
parameter before training, but the other five artificial intelligence
methods need parameter setting before training, which signifi-
cantly affects the performance of FDP models trained. Third, for
NN and EA, different times of training on a certain data set may re-
Table 1
The comparison of training characteristics among six typical artificial intelligence classification algorithms.
Training models/rules before Needing parameter setting before
FDP training
NN Yes Yes
SVM Yes Yes
EA Yes Yes
CBR No Yes
RS Yes Yes
DT Yes No
45
sult in different FDP models for certain degree of randomness in
the training process.
3.2. Hybrid single classifier methods for FDP
Many researchers studied on hybrid FDP methods based on two
or three algorithms, and the most popular forms are integrating
NN, CBR or SVM with other techniques. They are categorized into
three types as shown in Fig. 1.
3.2.1. One algorithm is applied to choose features for another
classification algorithm
It is a very common hybrid paradigm to use the first technique
for feature selection and the second for classification, which is a
two-stage modeling process. As shown by Fig. 1(1), if the first stage
applies certain evolution algorithm to optimize the feature portfo-
lio and uses a classification performance measure as the object
function, it will embed the classification modeling into the feature
selection process. Other than this situation, feature selection and
classification modeling are usually two independent sequential
stages.
3.2.1.1. Hybrid NN for FDP. Back et al. [8] and Anandarajan et al. [4]
combined NN with GA. They used GA to select input variables for
NN and established GA-NN model to further improve FDP perfor-
mance. Ravisankar et al. [96] and Ravisankar and Ravi [97] also
constructed several hybrids in such a paradigm. In the former, each
hybrid comprised two of the multilayer feed forward NN, probabi-
listic NN, RS and genetic programming (GP), and GP-GP hybrid
showed the best performance at the significance level of 10%. In
the latter, features were firstly selected by t-statistic, f-statistic,
or Group Method of Data Handling (GMDH, a relatively unexplored
NN), and classifiers were trained by GMDH, counter propagation
NN and fuzzy adaptive resonance theory map. As a result,
GMDH-GMDH and t-statistic-GMDH outperformed others.
3.2.1.2. Hybrid SVM for FDP. Yeh et al. [133] built a two-stage hy-
brid model that integrates RS theory and SVM, called as RST-
SVM. Redundant attributes were reduced by RS and then business
failure was predicted by SVM, and it was proved to outperform
RST-BPN. Lin et al. [73] trained a SVM FDP model after feature
dimensionality reduction though isometric feature mapping (ISO-
MAP) algorithm, one of the most developed dimensionality reduc-
tion techniques. It produced better performance when compared
with the PCA-SVM hybrid.
3.2.1.3. Hybrid CBR for FDP. Ahn and Kim [1] put forward a GA-CBR
hybrid bankruptcy prediction method, in which GA was used to
optimize feature weighting and instance selection simultaneously.
Such a hybrid obtained higher prediction accuracy than conven-
tional CBR, but it needed much more modeling time and computer
resource. Li et al. [66] solely used GA to select feature for CBR and
applied the hybrid algorithm in FDP. Cho et al. [26] used DT to
Fixed model structure for different times of training based on the same data and
parameters
No
Yes
No
Yes
Yes
Yes
46 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
Feature selection
Data set
method
(1) One algorithm is applied to choose features for another classification algorithm
Optimization
Data set
method
(2) One algorithm is applied to optimize parameters for another classification algorithm
New classification algorithm
Data set
Algorithm 1
(3) A new classification algorithm is produced by integrating principles of two or more algorithms
Fig. 1. Principles of three types of hybrid single classifier methods for FDP.
draw explanatory variables for bankruptcy prediction based on
CBR using the Mahalanobis distance, and it outperformed the
CBR method using Euclidean distance, Logit, and NN.
3.2.2. One algorithm is applied to optimize parameters for the other
classification algorithm
This hybrid paradigm is usually designed for the classification
algorithms that need parameter setting before model training,
especially for the classification algorithms such as NN and SVM
whose parameter values are critical to the final FDP models. As
shown by Fig. 1(2), although parameter optimization and classifi-
cation modeling are two sequential stages, classification algo-
rithms should also be used in the parameter optimization stage,
in which the evolution methods use classification performance
measures as the object function for optimizing parameters.
3.2.2.1. Hybrid SVM for FDP. Wu et al. [128] integrated real-valued
GA (RGA) with SVM, so that the optimal parameters of SVM can be
automatically optimized by RGA considering the predictive accu-
racy and generalization ability simultaneously. RGA-SVM showed
better experimental results than the pure SVM as well as DA, Logit,
Probit, and BPN. Min et al. [81] also proposed a GA-SVM hybrid
model for bankruptcy prediction, but they used GA to optimize
both feature selection and SVM parameters, to significantly im-
prove the predictive ability of SVM.
3.2.2.2. Hybrid NN for FDP. Chaudhan et al. [21] used differential
evolution (DE) for optimizing weights of wavelet neural network
(WNN), with FDP results indicating that DEWNN outperformed ini-
tial WNN and threshold accepting WNN (TAWNN). Hu [44] devel-
oped an ELECTRE-based single-layer perceptron (SLP) approach
and GA was then designed to determine its connection weights.
Its application to FDP demonstrated that it performed better than
the traditional SLP, the multi-layer perceptron, and some other sin-
gle classifier methods. Pendharkar [90] focused on FDP by integrat-
ing cost-sensitive learning with GA-NN through using posterior
probability for minimizing total misclassification cost as the fitness
function of GA, and it effectively helped the model improve the FDP
performance with imbalanced samples.
Classification
FDP model
algorithm
Classification
FDP model
algorithm
FDP model
Algorithm 2
3.2.3. A new classification algorithm is produced by integrating
principles of two or more methods
Different from the former two hybrid types that belong to two-
stage integration, this type of hybrid paradigm is an inner fusion of
two algorithms to produce a new classification algorithm (see
Fig. 1(3)), which is expected to be more effective for FDP modeling
than either original algorithm.
Cheng et al. [25] proposed a FDP method by embedding Logit
into radial basis function NN, in which the logistic function was
used as the active function between the hidden nodes and the out-
put node, and it outperformed both the Logit model and the BPNN.
Hua et al. [48] developed a method called as binary discriminant
rule for corporate FDP, which modified the outputs of the SVM
classifiers according to the result of logistic regression analysis,
and its prediction effect was better than the pure SVM. Chaudhuri
and De [22] integrated SVM with fuzzy membership functions to
propose a new classification tool called as FSVM, and it was effec-
tive in their bankruptcy prediction experiment for large
organizations.
3.2.4. Comments on hybrid single classifier methods for FDP
Studies on hybrid single classifier methods for FDP are almost
present in the 21st century, and began to boom especially in the re-
cent five years. This indicates that hybrid method for FDP is a new
subfield of FDP research that appeals to the current researchers.
Among the three hybridization forms, the first two paradigms that
are two-stage integration of two algorithms are more common
than the third paradigm, which needs inner embedding of two
algorithms with much more innovation. Therefore, it is worth
exploring how to produce some new hybrid classification algo-
rithms that are effective for FDP, and more than one form of
hybridization can be further integrated to obtain more effective
FDP tools.
3.3. Ensemble methods for FDP
In recent years, ensemble methods became another fruitful to-
pic in FDP field. An ensemble system can exploit each base classi-
fier’s unique information for classification, and it is expected to
produce smaller error variance than each base classifier in stand-
alone mode. Though the pioneering work on ensemble was done
early by Bates and Granger [12], its application to FDP firstly
emerged in Jo and Han [52] as far as we know and began to rise
 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
only recently after 2005. There are mainly two forms of classifier
ensemble: parallel and serial.
3.3.1. Parallel ensemble methods for FDP
In a parallel ensemble system, the classification results of multi-
ple classifiers are combined according to the schemes of majority
voting, weighted majority voting, product rule, minimum or max-
imum, Borda count, simple average, etc. [43]. There exist mainly
three approaches to generate base-level classifiers [120]: (1) gen-
erating classifiers by applying different learning algorithms (with
heterogeneous model representations) to a single data set, (2)
applying a single learning algorithm to different versions of a given
data set with different samples and features, and (3) applying a
single learning algorithm with different parameter settings to a
single data set.
3.3.1.1. Ensemble with different algorithms. This ensemble approach
was early used in FDP. Its overall framework is shown in Fig. 2. It
uses several classification algorithms to generate several FDP mod-
els with different representations, which are believed to contain
complementary classification information. By combining the out-
puts of these FDP models, the ensemble system obtains the final
FDP result that is more accurate and stable than member models.
For example, Jo and Han [52] utilized MDA, CBR and NN to gen-
erate base classifiers and integrated their predicted values by
weighted sum scheme to reduce the bankruptcy prediction error.
Ravikumar and Ravi [98] developed a set of ensemble classifiers
by simple majority voting scheme based on original seven algo-
rithms. Each time, two, three, four, five or six classifiers with high-
est classification rates and least Type-I error were selected to
construct the best ensemble classier, which outperformed constit-
uent stand-alone models. Sun and Li [111,112] investigated
weighted majority voting combination of multiple diversified clas-
sifiers that were generated by MDA, Logit, NN, DT, SVM and CBR,
and obtained higher average accuracy and lower variation coeffi-
cient than any base classifier. Ravi et al. [94] combined a multi-lay-
MDA
Logit
NN
Data set CBR
SVM
DT
Fig. 2. Framework of ensemble FDP system with different algorithms.
Training set 1
Training set 2
Sampling
Classification
Data set Training set 3
Or algorithm
Featuring
Training set n
Fig. 3. Framework of ensemble FDP system with one algorithm under different samples or features.
47
ered feed forward BPNN, a probabilistic NN, a radial basis function
NN, SVM, DT, and a fuzzy rule classifier to be an ensemble system
for FDP, and demonstrated that the ensemble yield lower Type I
and II errors.
3.3.1.2. Ensemble with one algorithm under different samples or
features. The framework of ensemble FDP system with one algo-
rithm under different samples or features is shown in Fig. 3. This
ensemble approach tries to produce multiple diverse training data-
sets from the original one by a sampling or featuring mechanism,
so that a classification algorithm can train on them to construct
multiple FDP models that have certain degree of diversity among
each other. Certain combination mechanism can also be used to
combine the outputs of different FDP models for the final FDP re-
sult. This kind of ensemble method tries to make full use of differ-
ent fragments of information contained in the original data set and
thus improves the FDP performance for a given classification
algorithm.
Bagging and Boosting are the two most popular ensemble
methods that apply a single learning algorithm to different ver-
sions of a given data set. Bagging and Boosting (including Ada-
Boost) ensembles based on NN were widely applied in FDP
researches such West et al. [126], Alfaro et al. [2], and Kim and
Kang [56]. They had the generalization ability superior to the single
NN model. Sun et al. [110] constructed AdaBoost ensemble respec-
tively with single attribute test (SAT) and DT for FDP, and found
that AdaBoost-SAT outperformed AdaBoost-DT, single DT and sin-
gle SVM, indicating that AdaBoost is more suitable for weak learn-
ers. Kim and Upneja [57] compared the predictive and
discriminatory performances of AdaBoosted DT models with single
DT models for publicly traded US restaurants for the period from
1988 to 2010, and AdaBoosted DT model demonstrated the best
prediction performance with the smallest error in overall and type
I error rates. Besides, Random Subspace is another ensemble meth-
od that uses different versions of a given data set to produce base
classifiers. Namely, each individual classifier uses only a subset of
FDP model 1
FDP model 2
FDP model 3
Combination FDP result
FDP model 4 mechanism
FDP model 5
FDP model 6
FDP model 1
FDP model 2
Combination
FDP model 3 FDP result
mechanism
FDP model n
48 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
all features for training and testing. Nanni and Lumini [82] found
that Random Subspace outperformed Bagging, Class Switching,
and Rotation Forest. Li et al. [67] integrated Random Subspace
method with Logit for FDP, and improved the FDP performance
of Logit models significantly. Li and Sun [69] proposed a principal
component CBR ensemble method that produced diverse base
models by different features and different algorithms simulta-
neously to effectively improve the performance of CBR in FDP.
The different feature sets were the initial ones and those respec-
tively selected by stepwise MDA, stepwise Logit and t-test. Two
CBR algorithms respectively with Euclidean Manhattan metrics
were used to construct CBR classifiers.
3.3.1.3. Ensemble with one algorithm under different parameters. This
ensemble method is applicable to classification algorithms that can
train different FDP models with different parameter values, e.g. NN
and SVM. Because improper parameter settings may lead to terri-
bly bad model performance and the number of FDP models trained
with optimized parameter values is usually limited, an ensemble
system constructed under the thought of one algorithm under dif-
ferent parameters alone usually does not have enough diversity. As
a result, it is usually combined with ensemble under different sam-
ples or features and the framework is shown in Fig. 4.
Tsai and Wu [122] constructed an NN ensemble by mainly using
different parameters and also using different versions of the same
training set. However, it did not outperform the single best NN
classifier in many cases, and it was attributed to too small training
dataset for diversified single classifiers and the binary classification
problem of FDP. Sun and Li [137] constructed a SVM ensemble
whose candidate single classifiers were trained by SVM algorithms
with different kernel functions and parameters on different feature
subsets of one initial dataset, and indicated that it significantly
outperformed individual SVM classifier when the number of base
classifiers in SVM ensemble was properly set.
3.3.2. Serial ensemble methods for FDP
Different from parallel combination, a serial ensemble system
arranges several base classifiers in sequence and selects the result
Training
set 1
Sampling
Training Classification
Data set algorithm
Or set 2
Featuring
Training
set n
Fig. 4. Framework of ensemble FDP system with one algorithm under different parameters and different samples or features simultaneously.
FDP model 1 FDP model 2 FDP model 3
Fig. 5. Framework of serial ensemble FDP system.
of one base classifier as the final output according to certain prin-
ciples. However, the methods to produce candidate FDP models in
parallel ensemble systems are still suitable for serial ensemble sys-
tems. Fig. 5 shows the framework of serial ensemble FDP system, in
which a base model except the last one has an effective output only
when it is triggered by the base model in front of it and its output
class has enough credibility simultaneously. The last base model n
in the serial FDP system can be either a single classifier or a parallel
ensemble classifier, which is usually considered to have overall
good FDP performance. For example, Hung and Chen [50] proposed
a selective ensemble for bankruptcy prediction, which selects some
suitable classifiers on the base of the expected probability of each
individual classifier and uses a parallel voting ensemble as the last
base model. Sun and Li [113] applied the serial ensemble method
for FDP by designing two selection operators for each class’s best
classifier and the wholly best single classifier. However, serial
ensemble methods did not show much superiority to the best base
classifier for the FDP problem with two categories.
3.3.3. Comments on ensemble methods for FDP
Classifier ensemble, which is also named as combination of
multiple classifiers, has shown much superiority for FDP. However,
the current researches almost focused on the effectiveness and fea-
sibility of different forms of ensemble classifiers for FDP by com-
prehensive comparisons, and some problems still need to be
further explored. For example, how to selectively choose partial
base classifiers from candidate ones to construct more effective
classifier ensembles for FDP? What kind of measures is more suit-
able for evaluating candidate classifiers considering both predic-
tive ability and diversity? Whether other combination
mechanisms instead of voting work better for FDP?
3.4. Dynamic FDP modeling for disposal of financial distress concept
drift
It is a real-world problem how to update the FDP model dynam-
ically when the new sample data batches gradually emerge with
time going on. The sample data that flow in at intervals may be col-
Parameters 1 FDP model 1
Parameters m FDP model m
Parameters 1
Combination FDP
mechanism result
Parameters m
Parameters 1
Parameters m FDP model m×n
Distress
FDP
… FDP model n result
Non-distress
 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
lected by two ways: one from different companies and the other
from different time points of certain company. Dynamic FDP mod-
eling in the former case is considered as lateral and that in the lat-
ter case is considered as longitudinal. Either lateral or longitudinal
dynamic FDP modeling tries to construct a model updating mech-
anism that can make the FDP model keep effective with time going
on. The core thought of dynamic FDP modeling is shown in Fig. 6,
and the key problem is how to design the FDP updating
mechanism.
3.4.1. Lateral dynamic modeling for FDP
Sun and Li [115] firstly explored the financial distress concept
drift (FDCD) that may behave in two ways: real and virtual, and at-
tempted to treat the virtual one by dynamic FDP modeling using
five instance selection methods, namely full memory windowing,
no memory windowing, windowing with fixed size, windowing
with adaptable size, and batch selection. They indicated that vir-
tual FDCD existed and the dynamic FDP models (particularly win-
dowing with fixed size and batch selection) outperformed static
ones. Sun et al. [138] further proposed a new FDP method for FDCD
that is called as adaptive and dynamic ensemble (ADE) of SVM
(ADE-SVM). It was divided into three steps: incremental construc-
tion of candidate SVMs, adaptive selection of base SVMs for the
current financial distress concept, and dynamic combination of
multiple SVMs. It was proved that ADE-SVM had better FDP perfor-
mance than the above instance selection methods.
3.4.2. Longitudinal dynamic modeling for FDP
Sun et al. [108] proposed a dynamic FDP method named as
SFFS-PC-NN optimized by GA with an individual enterprise’s longi-
tudinal data streams, so that a company’s ex-post financial situa-
tion evaluation was combined with its ex-ante FDP. In the
process of longitudinal dynamic FDP modeling, the label for a com-
pany’s financial condition at certain time point may varies with the
drift of relative FDCD, which makes it more effective and suitable
for a specific company’s financial risk management.
3.4.3. Comments on dynamic FDP modeling methods
Both lateral and longitudinal dynamic FDP modeling methods
use incremental sample data to update FDP models with time
going on, trying to solve the FDCD problem. Since the external
and internal environment for an enterprise always changes con-
stantly, such study on dynamic FDP modeling is particularly
important for keeping the adaptability of FDP models. However,
such a research topic in FDP just began to obtain focus of the area,
and how to dispose the problem of FDCD by proposing more crea-
tive and effective dynamic FDP modeling approaches that consider
the factor of time leaves to be further studied.
FDP model t
FDP modeling based on candidate data batches from 1 to n
Data Batch 1 Data Batch 2 …. Data Batch n Data Batch n+1
FDP modeling based on candidate data batches from 1 to n+1
Fig. 6. The core thought of dynamic FDP modeling.
49
3.5. FDP based on decision implementations and comments
3.5.1. FDP based on decision implementations
Existing quantitative FDP methods almost only took financial
ratios into consideration and paid little attention to the important
role of experts’ experiential knowledge and non-financial informa-
tion. Sun and Li [114] brought forward a group decision making
method for financial distress early warning by designing qualita-
tive attribute system and the mechanism for integrating multiple
experts’ opinion for financial distress diagnosis.
Some researches applied social network analysis to study the
links and effects of one company’s failure on others related. When
the customers of a sound firm are financially distressed, then this
firm gets into financial difficulties with a probability ranging from
3.4% to 11.3%, depending on the level of collection costs and the de-
gree of diversification [6]. Such bankruptcy propagation among
suppliers/customers in supply chains connected by trade credit
can be upward, downward, or both upward and downward, which
is determined by whether payments are delayed and whether
firms can instantly adapt their resources to the input received
[7]. In a credit network model that includes firms and banks, the
bankruptcy of a borrower may lead to the lender’s bankruptcy or
an increase of interest rate provided by the surviving lender, which
further causes more borrowers already on the verge of bankruptcy
to reach a tipping point and default [41]. Thus an avalanche of
bankruptcies may ensue. Xu et al. [131] verified that supply chain
coordination like information sharing and vendor-managed inven-
tory is effective in reducing the risk of bankruptcy. Furthermore,
Hua et al. [47] studied on bankruptcy propagation in a supply
chain, and found that operational interactions between firms and
operational decisions made by firms in a supply chain were impor-
tant causes of such bankruptcy propagation. Meanwhile, impacts
of these operational issues and decisions depended on financial
decisions.
3.5.2. Comments
The problem of FDP can be regarded as a group decision-making
problem, and the process of FDP should integrate knowledge of
various experts related to the firm, e.g., managers, stockholders,
governmental officials. Therefore, group decision-making methods
for FDP should gain more focus and become a necessary supple-
ment of quantitative FDP techniques. Meanwhile, investigation
on FDP from the view of credit chain and supply chain manage-
ment is valuable, because one firm’s failure is possible to result
in the failure of an entire chain. In other words, identification of
key actors whose distress can affect the others will further help
analysis of predictors of FDP, and if some factors related to credit
chain and supply chain operations are considered as the input vari-
ables for FDP, the effectiveness of FDP may be further improved.
FDP result
for time t+1
t FDP model
updating
mechanism
t+1
FDP result
FDP model t+1 for time t+2
50 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
4. Sampling and featuring methods for FDP
4.1. Sampling methods for FDP
4.1.1. Training and testing sampling
Experimental samples of each class are often divided into train-
ing and testing samples randomly. Training data are used to estab-
lish FDP model based on statistical or artificial intelligence
techniques. Testing data are used to test the model’s generalization
ability and robustness. Many literatures [3,77,42,103,54,51], etc.)
on FDP used accuracies on testing data to measure the efficiency
of FDP models, because hold-out testing ensures the independence
of training data and testing data. However, the randomness of sam-
ple division in hold-out testing may result in stochastic FDP perfor-
mance, making the conclusion less persuasive. Therefore, some
studies used thirty or more times of hold-out testing to obtain
thirty or more testing accuracies for a given FDP approach, so that
statistical mean comparison and deviation analysis can be imple-
mented for more persuasive conclusions [112,110,70].
If the whole sample is randomly divided into K folds and each
time one fold is used for testing and the remaining (K 1) folds
are used for training, the K-fold cross-validation accuracy can be
computed after K times of iterations. K-fold cross-validation proce-
dure is preferred to hold-out procedure especially for small sample
size because it is a more objective performance measure [36].
When K equals to the total sample number, it is unbiased leave-
one-out validation, which needs much more computational cost
and is only suitable for less complicated approaches with a rela-
tively small data set [109]. The K-fold cross-validation can also
be repeated for more than thirty times for statistical analysis.
4.1.2. Cross-industry sampling and single industry sampling
To ensure sample size, most FDP researches used cross-industry
samples, in which each distressed company was matched with a
healthy one from the same industry but different pairs may belong
to different industries. Some studies also considered the impact of
industry on FDP modeling. Platt and Platt [91] showed that indus-
try adjustment for financial ratios improved the effectiveness of
FDP modeling, and the model trained from one industry was often
ineffective for FDP of other industries. Grice and Ingram [42] stud-
ied on the sensitivity of Altman’s model, and concluded that the
model trained with only manufacturing samples had significantly
higher overall accuracy than the model trained with both manufac-
turing and non-manufacturing samples.
With the development of research database, some researches
began to focus on FDP modeling for a specific industry such as
manufacturing [135], retail [45,46], hotel [70], restaurant [57],
Table 2
Representative FDP literatures based on imbalanced datasets.
Authors (Year) Training sample
Distressed Non-
distressed
McKee and Greenstein 54 288
[77]
66 336
59 240
72 292
76 309
Grice and Ingram [42] 148 824
Sarkar and Sriram [103] 118 793
Jones and Hensher [54] 194 (78 solvency difficulty and 116 failure 2838
samples)
Hwang et al. [51] 50% of 79 50% of 156
Ding et al. [31] 28 97
and dotcom [19,96]. Since different industries face different levels
of competition, the likelihood of financial distress can differ for
firms in different industries [57]. FDP modeling based on single
industry sampling can help construct more efficient FDP models
for a specific industry.
4.1.3. Balanced sampling and imbalanced sampling
Most FDP researches used balanced samples
[3,60,52,53,87,107,112,115]. However, Zmijewski [136] showed
that if the ratio of distressed to non-distressed samples evidently
deviated from the real-world population, it would distort the mod-
el’s prediction capability. Specifically, the proportion of distressed
samples is negatively related with the type I error rate (to recog-
nize the distressed as non-distressed), while it is positively related
with the type II error rate (to recognize the non- distressed as dis-
tressed). That is, if the proportion of distressed samples is higher
than that in the real-world population, it will lead to the underes-
timation of the type I error and the overestimation of the type II er-
ror, and vice versa.
Later on, some FDP studies applied imbalanced samples, also
called proportional samples, in which the proportion of distressed
sample should be closer to that in the real-world population.
Namely, the FDP experiments should use fewer distressed and
more non-distressed companies. Table 2 shows the sample infor-
mation of some representative FDP literatures based on imbal-
anced datasets [77,42,103,54,51]. For example, McKee and
Greenstein [77] used five groups of imbalanced training and test-
ing datasets, and the proportion of distress to non-distress in test-
ing samples reflects the real-world proportion. While the
proportions in some literatures are much lower than 1:10
[51,31,45,46]. Besides Gepp et al. [38] used an imbalanced dataset
consisting of 58 failed and 142 non-failed samples and carried out
fivefold cross-validation for the DT FDP method.
The above literatures did not take treatment measures for
imbalanced training dada sets, but tuned the models’ cut-offs to
ensure the prediction performance for skewed testing data sets.
Such an approach has the limitation that the cut-off should be
determined before prediction, which is a difficult task in real
world, and the prediction performance will be low if the cut-off
is not set properly. Li and Sum [70] used an over-sampling method
to generate new minority samples to make the training dataset
balanced, and found that the FDP model constructed on the cor-
rected balanced training data set significantly outperformed the
FDP model trained on the original imbalanced data set. In fact,
there are several sampling methods that can be used to treat the
problem of imbalanced datasets. Crone and Finlay [28] applied
both over-sampling and under-sampling methods to balance the
Testing sample
Distressed Non-
distressed
12 1154
16 2683
19 2468
19 2643
18 3396
148 854
25 203
229 (119 solvency difficulty and 110 failure 4980
samples)
50% of 79 50% of 156
28 97
 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
original imbalanced credit scoring datasets. They provided evi-
dence that over-sampling significantly increases the accuracy rela-
tive to under-sampling across all algorithms, and Logit is less
sensitive to the balancing preprocessing than MDA and CART DT.
4.2. Comments on sampling methods for FDP
Training and testing sampling relates to how to train and assess
FDP models with available samples. It provides a way to simulate
real-world FDP process, which produces statistical results for per-
formance estimation of FDP models.
A cross-industry data set is usually applied for PDF modeling
when the size of single industry data set is too small, especially
when the number of distressed samples is too small. The knowl-
edge of FDP differs among different industries, which have differ-
ent financial characteristics. Therefore, a single-industry dataset
is preferred when the volume of interested samples is not too
small.
The real-world problem of FDP related to imbalanced datasets.
Solutions for imbalanced data sets at data level include over-sam-
pling, under-sampling and a hybrid of them. Traditional FDP re-
searches used pairing strategy to balance datasets, which
essentially belongs to over-sampling. Besides, imbalanced prob-
lems can also be solved at model level, which adjusts the predictive
modeling by introducing a threshold parameter or cost-sensitive
learning. For FDP with imbalanced datasets, assessing models only
by predictive accuracies may provide misleading information. For
example, a model can produce an accuracy of 99% when predicting
all the samples as non-distressed, if the dataset consists of 99%
non-distressed samples and 1% distressed samples. Hence, FDP re-
searches based on imbalanced datasets should consider the Type I
and II error rates and some other measures such as sensitivity,
specificity, and F-measure.
5. Featuring methods for FDP
Financial experts have found that there are some abnormal
changes in financial or non-financial indicators before financial dis-
tress occurs. Therefore, financial distress can be predicted by
observing the characteristics of some feature indicators. Theorists
and practitioners are struggling to establish an effective feature
set for FDP.
5.1. Feature selection in classic statistical-technique-based literatures
of FDP
Beaver [13] selected the initial financial indicators by four
criteria:
(1) Popularity, namely frequent appearance in the previous
literatures.
(2) Apriority, namely having good performance in one of the
previous studies.
(3) Cash-flow concept, namely including some cash-flow ratios.
(4) Independence, namely excluding any indicators that can be
transformed from the selected indicators.
By meeting one of the first three criteria plus the fourth, he
chose 30 financial ratios from six areas to carry out the single var-
iable analysis, including cash-flow ratios, net-income ratios, debt
to total asset ratios, liquid asset to total asset ratios, liquid asset
to current debt ratios, and turnover ratios. He found that cash-flow
to total-debt ratio had the strongest ability to predict failure, fol-
lowed by the net-income to total-assets ratio, total debt to total as-
51
set, working capital to total assets, current ratio, and no-credit
interval.
Altman [3] built the initial feature set by choosing twenty-two
potential helpful financial ratios according to the two principles:
(1) Popularity in the literature.
(2) Potential relevancy to the study by his own professional
judgment.
To establish the final variable profile, the following four proce-
dures are utilized:
(1) Observation of the statistical significance of various alterna-
tive functions including determination of the relative contri-
butions of each independent variable.
(2) Evaluation of inter-correlations between the relevant
variables.
(3) Observation of the predictive accuracy of the various
profiles.
(4) Judgment of the analyst.
Five variables are finally selected, including working capital/to-
tal assets, retained earnings/total assets, earnings before interest
and taxes/total assets, market value equity/book value of total
debt, and sales/total assets.
According to simplicity principle, Ohlson [85] selected nine
financial ratios by including the five financial ratios frequently
present in previous literatures, as well as adding asset size, two vir-
tual variables representing whether net income is negative or po-
sitive and whether total liabilities exceeds total assets, and a
variable measuring net income’s trend. He found that company
size was an important predictor for financial distress, followed
by the financial structure.
Rose and Giroux [99] compared the means of one hundred and
thirty indicators that did not appear previously between forty-six
pairs of failed and non-failed companies. They found that thirty-
four indicators had significant difference. After combining these
indicators with the other twenty-seven indicators commonly used
in previous studies, they carried out stepwise MDA to establish a
final discriminant equation that included eighteen variables, to im-
prove the prediction accuracy. Hence, innovative use of new indi-
cators for new models may improve the prediction ability.
5.2. Qualitative selection of FDP features
On one hand, qualitative selection means that the features for
FDP modeling are selected subjectively by researchers according
to their analysis on different indicators. For instance, Kiviluoto
[139] subjectively selected the following four financial indicators:
operating margin, net income before depreciation and extraordi-
nary items, net income before the depreciation and extraordinary
items of the previous year, and equity ratio. Kim and Han [55] ex-
tracted expert qualitative decision rules by six qualitative attri-
butes including industry risk, management risk, financial
flexibility, credibility, competitiveness, operating risk. Sun and Li
[114] put forward seven first-level qualitative attributes for early
warning of financial distress based on group decision making.
On the other hand, qualitative selection also means directly
using the indicators that were used in previous literatures
[132,76,77], or subjectively and selectively adding or deleting
some indicators based on them. For example, Cielen et al. [27] di-
rectly selected eleven financial indicators from Foster [35] and
other previous researches. Pendharkar [89] directly chose five
financial indicators from Altman’s Z-Score model and Zeta score
mode. Zhang et al. [135] combined current ratio with the five vari-
ables in Altman’s Z-score model. More recently, Wu et al. [128] se-
52 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
lected nineteen financial ratios that were organized into four
groups and Chen [24] selected thirty-seven variables covering six
major types both based on prior FDP researches. While, Bose [14]
firstly identified fifteen popular financial ratios used in literatures,
and then added the other nine to capture the novelty of dot-com
companies.
5.3. Quantitative selection of FDP features
We considered a feature selection method quantitative as long
as quantitative approaches were employed. Thus, this section also
includes the combination use of qualitative and quantitative fea-
ture selection.
5.3.1. Quantitative feature selection
Based on the initial features subjectively or qualitatively se-
lected by researchers, quantitative statistical methods, artificial
intelligence methods or other methods are utilized to streamline
features. For instance, Jo and Han [52], Jo and Han [53], Park and
Han [87], Shin and Lee [106], and Ding et al. [31] selected variables
by the statistical methods of stepwise regression or t-test. Back
et al. (1996) [8] selected variables for MDA and Logit models by
stepwise regression, while selected variables for NN by integrating
GA. Galvao et al. [37] optimized the feature set for FDP with the cri-
teria of greatest information content and minimum multi-collin-
earity by GA.
Atiya [5] developed two feature systems: one based on financial
ratios alone and another based on financial ratios and stock-price-
based indicators. They obtained the best five or six inputs from a
pool of about 120 candidate inputs by using an initial prescreening
procedure based on individual indicator prediction accuracy and
correlation matrix and a subsequent cross-validation procedure.
The five indicators included: book value/total assets, cash flow/to-
tal assets, rate of change of cash flow per share, gross operating in-
come/total assets, and return on assets. The six indicators
included: book value/total assets, cash flow/total assets, price/cash
flow ratio, rate of change of stock price, rate of change of cash flow
per share, and stock price volatility. Li and Sun [68] integrated a
straightforward wrapper with SVM for FDP. A forward feature
selection method was used to implement the wrapper. Perfor-
mance of SVM on each feature was used to ranking indicators,
which is similar to the operation of Atiya [5]. Meanwhile, they also
investigated the feasibility of using linear SVMs as assessment
function in feature selection. The result indicated that the RBF
non-linear SVM with features selected by linear SVM performed
significantly better than all the other SVMs. Sung et al. [117] em-
ployed a data mining approach to solve the problem of FDP, and re-
vealed that the major features in predicting bankruptcy included:
cash flow to total assets, and productivity of capital under normal
conditions. Meanwhile, the indicators of cash flow to liabilities,
productivity of capital, and fixed assets to stockholders equity
and long-term liabilities were effective to predict financial distress
under crisis conditions. Their findings also indicated that the effec-
tive FDP models in crisis economic conditions and normal eco-
nomic conditions were different, which was also supported by
the finding of Li et al. [61].
In addition, Leshno and Spector [60] streamlined variables by
multi-step exclusion procedure and selected variables on the basis
of seventy initial financial parameters and ratios by the following
four steps:
(1) Include all variables in Altman’s Z-score model.
(2) Retain only one variable from each pair of variables with a
correlation coefficient of 0.7 or over.
(3) Exclude the variable which has lots of missing values from
each pair of highly correlated variables.
(4) Exclude the variable that is intuitively identified as less rel-
evant to FDP from each pair of highly correlated variables
which has the same number of missing values.
5.3.2. Quantitative feature extraction
Factor analysis (FA) and principal component analysis (PCA) are
also applied to feature extraction for FDP [134,24,110,69]. Different
from t-test or stepwise regression that selects efficient variables
from initials ones, FA or PCA reduces dimensions by extracting fac-
tors or principal components, which are new variables computed
from initial data. Tsai [121] compared five well-known feature
selection methods for FDP, which are t-test, correlation matrix,
stepwise regression, PCA and FA, and found that on average t-test
is superior to others and stepwise regression is on the second posi-
tion. This indicates that t-test is not only a simple feature selection
method but also an efficient one. Ravi and Pramodh [95] improved
performance of TAWNN in FDP by using features extracted by PCA.
The result indicated that the PCTANN outperformed the compared
techniques.
Besides, some other examples of quantitative featuring meth-
ods for FDP also include the references [79,1,96,97,133,73] in the
Section 3.2.1, where one algorithm is applied to choose features
for another classification algorithm to generate a hybrid FDP
method.
5.4. Comments on featuring methods for FDP
5.4.1. Advantage and disadvantage of qualitative and quantitative
featuring methods
Either qualitative or quantitative featuring method has its own
advantages and disadvantages. Pure subjective construction of fea-
ture system is usually appropriate for the exploratory stage of cer-
tain direction of FDP research when no similar literatures can be
referred to. Feature system constructed by this type of qualitative
method has strong subjectivity, and is sometimes lack of persua-
siveness. Qualitative selection based on previous researches
chooses representative indicators used by previous researches,
and the scientificity of feature set is supported by the results of
previous researches. It also has certain degree of subjectivity when
adding or deleting indicators selectively to adapt to different back-
grounds, and its applicability to other research background is not
enough.
Quantitative feature selection is less affected by subjectivity,
and it often can produce a feature set for FDP with greater informa-
tion content and improve modeling efficiency. It is a mainstream
method in current FDP research. However, it also may eventually
produce an efficient final feature set that is hard to be explained
or understood, and it is often unsuitable for constructing pure
qualitative attribute system that is necessary for specific FDP
method like group decision making.
5.4.2. Classifying featuring methods of FDP into filter and wrapper
Generally, there are two types of featuring methods: filter and
wrapper. Filter approaches make use of human’s experiential
expertise or statistical information of the dataset to carry out fea-
ture selection and are independent of the base classifier. Wrapper
approaches, on the other hand, use classification accuracies or cri-
teria derived from the classifier to rank the discriminative power of
all (or part) of the possible feature subsets and select the subset
that produces the best performance [83].
Therefore, qualitative selection of FDP features belongs to filter
method, because features are chosen without quantitative analysis
before certain kind of classification/prediction algorithm is used to
construct FDP model. However, quantitative featuring methods
may belong to either filter or wrapper. For example, the feature
selection/extraction methods like t-test, correlation matrix, PCA
 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56
and FA are all filter approaches. For stepwise regression like step-
wise MDA or stepwise Logit, it belongs to wrapper when MDA or
Logit is also used as the classification tool. However, it is a filter
method when the variables selected by them are used as input of
other classification algorithms. For the hybrid FDP method in
which one algorithm is applied to choose features for another clas-
sification algorithm, filter feature selection is applied if feature
selection and model construction are two independent stages,
while it is a wrapper when feature selection and model construc-
tion are integrated together and a performance measure derived
from the model is used to determine the result of feature selection.
6. Conclusions and future research topics in FDP
FDP is a hot exploratory issue in accounting, finance, business,
and engineering areas. It is gradually forming its own theoretical
system to be an independent subject. It has important practical sig-
nificance on improving awareness of financial risk, preventing cor-
porate financial distress, and avoiding bankruptcy liquidation. This
review classified researches in this subject into four categories:
namely, definition of financial distress concept, FDP modeling
methods, sampling methods, and featuring methods. Although
abundant articles have been published in this field, yet there are
still some valuable topics which need further explored and studies.
The main issues that need to be further investigated are summa-
rized as follows:
6.1. Developing simple but accurate predictive models
The current research objective of PDF is to find more accurate
predictive models, since even a cautious reduction of predictive er-
ror rates of predictive models is able to help people reduce the loss
in business significantly. In order to achieve this objective, several
state-of-the-art techniques are tried to be integrated to construct
an accurate model. However, by reviewing the achievements of
fulfilling the objective of investigating more accurate FDP models,
we find that lots of very complex models were developed. In order
to find more accurate predictive FDP models, we may neglect the
fact that FDP is a practice-oriented subject. The reduction on pre-
dictive error rate is not significant and valuable unless the model
is applied in forecasting financial distress in real world. However,
the complexity of models prevents them from being adopted by
industrial organizations and users. Since the use of FDP as a man-
agerial tool relates to financial income of an organization, the users
commonly will not apply a technique in their work unless they
understand the inside mechanism of the technique clearly. Thus,
they need simple FDP models, which hold the characteristics of
ease of interpretation, explanation, and understanding. Simple
models do not surly belong to inaccurate models. Gepp et al. [38]
provided some evidence that simpler models are able to produce
better predictive powers.
6.2. Developing dynamic modeling methods for FDP
In real-world FDP practice, it is a critical problem how to con-
sider the existence of FDCD and update FDP models effectively
when they become outdated with time going on. Current litera-
tures on FDP almost focus on algorithmic exploration that is on
the assumption that the data set for current FDP modeling is al-
ready constructed, and dynamic variation of modeling data with
gradual emergence of new financial distress samples is almost ne-
glected. Although some pilot work on this topic has already been
done, more effective methods for treating concept drift and dy-
namic FDP modeling with time process needs further attention
and deep research.
53
6.3. Developing FDP models based on decision implementations
Most current researches of FDP were carried out from the per-
spective of quantitative prediction, and far less attention were paid
to the importance of expertise and non-financial information. Gen-
erally speaking, before the outbreak of enterprise financial distress,
not only quantitative financial indicators have abnormal signs, but
also there exist many hidden peril of management that cannot be
quantified, which are often the source of outbreak of financial dis-
tress. Therefore, it is necessary to break the traditional concentra-
tion on quantitative FDP models that are based on financial
indicators, and to do further study on how to use expertise and
non-financial information to predict financial distress. As an
important branch in operational research and management sci-
ence, group decision-making methods have been applied to solve
many managerial problems and help improve management effi-
ciency. However, its application to FDP is not paid enough atten-
tion. In fact, financial distress early warning based on group
decision-making methods can provide important supplement for
quantitative FDP models, and help managers find the reasons for
enterprise financial distress, only on which effective managerial
measures can be taken to prevent further deterioration of financial
condition. Besides, more non-financial indicators should be consid-
ered in group decision-making FDP methods as well as traditional
quantitative FDP models. The mechanism of avoiding financial dis-
tress from the enterprise operation also needs further investiga-
tion. The competition between firms happens between the entire
supply chains. One firm falling into failure in a supply chain may
force the other firms in the chain to fail. Thus, how to avoid finan-
cial distress from the view of supply chain management needs to
be further investigated.
6.4. Developing imbalanced predictive models for FDP
The real-world problem of FDP consists of imbalanced datasets.
The traditional use of pairing strategy to produce balanced data
sets is a method for handling imbalanced samples, namely: the
use of expertise of human beings to balance the real-world imbal-
anced data sets. With the development of imbalanced data pro-
cessing, more techniques have demonstrated themselves useful
in FDP modeling. These techniques chiefly include data level solu-
tion for modeling with imbalanced samples, and model level solu-
tion for modeling with imbalanced samples. The cost-sensitive
learning technique is also a potential alternative for FDP imbal-
anced modeling. This topic needs further investigation, since it fits
the real-world characteristics of FDP.
6.5. Developing financial distress early warning system
The previous researches have not formed the overall framework
of financial distress early warning system, resulting in the situation
which is full of concrete algorithmic research but lack of frame-
work design of financial distress early warning information sys-
tem. This is not only unfavorable to the formation and
improvement of financial distress early warning system, but also
limits the application of existing specific FDP methods to the prac-
tice of enterprise. Therefore, it is necessary to study on the logic
system of financial distress early warning.
Acknowledgements
This research is partially supported by the National Natural Sci-
ence Foundation of China (Nos. 71371171, and 71171179), the
Humanity and Social Science Foundation of Ministry of Education
of China (No. 13YJC630140), the Zhejiang Provincial Natural Sci-
ence Foundation (LY13G010001, and LR13G010001), the Zhejiang
54 J. Sun et al. / Knowledge-Based Systems 57 (2014) 41–56

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