505

A publication of

CHEMICAL ENGINEERING TRANSACTIONS

VOL. 51, 2016 The Italian Association
of Chemical Engineering
Online at www.aidic.it/cet
Guest Editors: Tichun Wang, Hongyang Zhang, Lei Tian
Copyright © 2016, AIDIC Servizi S.r.l.,
ISBN 978-88-95608-43-3; ISSN 2283-9216 DOI: 10.3303/CET1651085

Financial Distress Prediction of K-means Clustering Based on

Genetic Algorithm and Rough Set Theory
Baozhen Hou
Xi'an International University, 18 Yudou Lu, Yanta District, Xi'an Shaanxi, PRC
[email protected]

To the enterprise, the financial risks are impersonal. If there is no scientific method to predict and prevent
financial risks, it is likely to cause the enterprise to fall into a difficult situation, even go bankrupt. In reality, the
financial crisis of enterprises is expressed as a gradual deterioration of the financial indicators. Therefore, the
financial crisis is symptomatic, and can be predicted. The main research direction of the current financial crisis
early warning is to looking for a better model to help enterprises to find the financial crisis earlier. In view of the
early warning of listed company’s financial crisis, this paper introduces the K clustering algorithm based on
genetic algorithm; overcomes some problems of traditional K-means clustering, such as sensitive to the initial
cluster center, easy to fall into the local optimal value; puts forward a new model which is K-means clustering
model based on genetic algorithm. Then, we combine Rough set theory to evaluate financial position of the
company comprehensively, and test the rationality of the model classification. Studies have shown that K-
means clustering based on genetic algorithm can divide the company efficiently. The goodness of fit to
evaluation results of rough set is up to 87.5%.

1. Introduction
For enterprises, if there is no scientific method to predict and prevent financial risks, it will make the enterprise
fall into trouble, and even cause bankruptcy. Therefore, it is very necessary to find a sensitive and accurate
financial early-warning method. Since 1930s, methods already have more than a dozen through many years
development. Over the years, scholars have made the multi-level researches about how to predict the
financial crisis of enterprises more accurately. These studies are focused on the following four aspects:
1) The definition of enterprise financial crisis. Altman(1994) defined "entering legal bankruptcy" as the main
mark of financial crisis. Deakin(1972) regarded the financial crisis as an enterprise that had been bankrupt or
had sold out for insolvency. Foster(1986) treated the financial crisis as a business that must be massive
restructured. In our country, Chen Jing(1999) used serious sustained loss as the symbol of financial crisis.
Zhao Ailing (2000) took businesses unable to pay due debts or expenses as the symbol of financial crisis. Liu
Liang(2006) believed that the financial crisis is defined as the company continued losses. He defined
companies suffering losses for two years as a financial crisis company. At present, for company stock in
abnormal condition, the Shanghai and Shenzhen Stock Exchange takes special treatments for it. The special
treatments include two methods that are delisting risk warning (st*) and other special treatment.
2) Financial crisis early warning model construction. Niu Xiaochen(2014) combined neural network model and
rough set theory to predict the financial situation of enterprises. Bao Xinzhong(2013) applied two theories that
were K-means algorithm based on particle swarm optimization and rough set theory to predict the financial
situation of enterprises. Yang Shue et al. (2005) imposed Back Propagation (BP) neural network model on
predict enterprises’ financial condition. Lang fan(2008) used improved support vector machine model based
on genetic algorithm to predict enterprises’ financial condition. Thus, searching for a better algorithm is one of
the trends of the current financial distress prediction in various countries. Lai Yuxia(2008) proposed a genetic
algorithm based K-means clustering analysis, and improved the original K-means clustering algorithm to
construct a better clustering model.
3) Selection of synthetically evaluating indexes. Altman (1968) selected Working Capital / Total Assets,
Retained Earnings / Total Assets and other financial indicators in his study. Then, he found that EBIT/ Total

Please cite this article as: Hou B.Z., 2016, Financial distress prediction of k-means clustering based on genetic algorithm and rough set
theory, Chemical Engineering Transactions, 51, 505-510 DOI:10.3303/CET1651085
506

Assets, Sales Revenue / Total Assets, Market Value of Shareholder Equity /Book Value of Total Liabilities
showed good predictive ability. In 2006, on the basis of actual situation, Berrada T (2006) selected different
methods to find the sensitive indicators by using net operating profit rate and return on equity ratio to construct
the early warning model which were obtained good effect. In our country, in the research of financial early
warning, song Biao et al. (2015) selected the Liquidity Ratio, Quick Ratio and other 32 financial indicators as
the alternative variables. Finally, there are only 5 indicators by using the normal distribution test, such as the
Ratio of Fixed Assets, Intangible Assets, etc.
4) Sample selection. Altman et al. (1968) used the data of industrial enterprises Italy between 1982 and 1992
as samples in the study of financial early-warning. In the study, Niu Xiaochen (2014) based on companies
listed in the Shanghai and Shenzhen Stock Exchange, and selected the companies which were specially
treated from 2010 to 2013.
According to the conclusions above, we define those companies suffered special treatment as the financial
distress companies. In addition, we use the K-mean clustering algorithm based on genetic algorithm, which is
commonly use in the field of financial early warning. In this paper, we select 28 financial indicators as examine
variables, and preserve 7 indicators according to the significant test. We select 24 A shares of listing
Corporation as the objects of study. Half of them get special treatment and the others of them are normal
financial companies.

2. Algorithm Description
2.1 Architecture of Wireless Sensor Networks
K-means algorithm is one of the most widely used clustering algorithm. The algorithm takes K as parameter,
and divides the n objects into K clusters, which makes higher similarity between the intra-cluster, and lower
similarity between the inter-clusters. First, the algorithm randomly chooses K objects, each object represents
an average or center of a cluster. For the remainder of each object, the algorithm assigns it to the nearest
cluster according to the distance from the center of each cluster, then the algorithm recalculates the average
value of each cluster. We repeat this progress until the criterion function converges.
The criterion function is as follows:
K
2
E  
i 1X Ci
X  Xi (1)

Among them, Xi is the average value of Ci cluster.

K-mean algorithm is described as follows:
(1) K-records are randomly selected as the initial cluster centers.
(2) Calculating the distance between each record and the K cluster center, and regards this point assigned to
the clustering which is nearest to it.
(3) Calculating the centroid (mean value) of each aggregation and the distance between each object and the
center object, and re-dividing the corresponding object according to the minimum distance. Repeat this step
until the formula (1) no longer changes significantly.
Generally, the smaller the value of the formula (1) is, the better the clustering effect is.
2.2 K-mean Clustering Algorithm Based on Genetic Algorithm
The genetic algorithm is applied to cluster analysis. The combination of the global optimal searching ability of
genetic algorithm and the local optimization ability of cluster analysis can overcome locality of clustering
algorithm. In the process of population evolution, the K-means operation is introduced. Because of the strong
local search ability of K, the convergence speed of genetic algorithm can be greatly improved after the
introduction of K-means. At the same time, in order to avoid prematurity, the adaptive method is used to adjust
the crossover probability and mutation probability dynamically in the population, so that it can be changed
automatically with the degree of adaptive function. The specific steps of the algorithm are summarized as
follows:
Step 1: Chromosome coding. We code floating point number based on cluster center, and code the center of
each category as the chromosome.
Step 2: Generating initial population. In order to obtain the global optimal solution, the initial population is
randomly generated. The algorithm randomly assigns each sample to a class as the initial clustering. Then it
uses the cluster centers of each cluster as the initial individual chromosome encoded string. Finally, the
algorithm generates M initial individuals, so as to generate the first generation of population.
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Step 3: Selecting the fitness function. The fitness function is used to measure the individual groups in the
optimal solution, in the meantime individuals may reach or close to the optimal solution of the excellent
degree. In this paper, we use the formula (1) to construct the fitness function:
f=b/(1+E) (2)
Among them, b is constant.
Step 4: Selecting crossover operator, mutation operator, genetic operator. We calculate the probability of
individual be selected on the basis of the fitness. Then we replace the worst individual with the current optimal
individual in the new population. This article implements the crossover according to the following formula:

X At 1  aX At  1- a  X Bt , X Bt 1 （1- a）X At  aX Bt , a   0,1 (3)

For each aberrance point, algorithm uses a random number in the value of the corresponding gene to replace
the original gene and makes the mutation. Algorithm uses the non-fixed probability value for the adaptive
genetic operator in the process of genetic algorithm. For the bigger fitness individuals, algorithm gives it
corresponding crossover and mutation probability. For example, algorithm sets the corresponding crossover
and mutation probability to the individuals which have a bigger fitness. In this way, the adaptive genetic
algorithm can keep the diversity of the population while ensuring the convergence of the algorithm.
Step 5: K-means operation. Firstly, we define the values of the new population after the mutation as centered,
and assign each data point to the nearest class, so as to form a new cluster. Secondly, we calculate the new
cluster center according to the new cluster partition, and replace the original encoding value.
Step 6: Loop termination. Cyclic iteration starts at 0, plus 1 for each cycle. If the current cyclic iteration is less
than the pre-specified maximum cycle, then the cycle is continued; otherwise, the end of the cycle. If the
current cyclic iteration is less than the predetermined maximum cyclic iteration, the loop continues; otherwise,
this loop ends.
2.3 Rough Set
In this paper, rough set is used to attribute reduction of the financial data of the listing Corporation. In the
rough set, an information system is defined as S=(U, C, D, V, f). Among them, U is a collection of objects; C
and D is collections of attributes; V is a collection of attribute values; and F is an information function, which
gives an information value to each attribute of each object in the U. Decision table is a special kind of
knowledge expression system. It is a four tuples T=U, CD, V, f. It means that when certain conditions are
met, how decisions should be performed. Definitions are as follows:

Definition 1: The lower approximation of the set X on the R is defined as R_(X)={xU:[x]RX}. R_(X) also
known as the R positive domain of X, marked as POSR(X).

Definition 2: In decision table S=(U, C, D, V, f), the dependency of decision attribute D on conditional attribute
set BC is defined as  B  D   POS B  D  U .

Definition 3: In decision table S=(U, C, D, V, f), cC, the importance of the condition attribute (index) C is
defined as Si g c    c  D -  C - c  D .

Definition 4: The weight of the condition attribute (index) C is defined as W  c   Sig  c  .

CSig  
o

In the traditional rough set theory, the attribute is regarded as redundant when the attribute importance is 0.
At this point, attribute reduction should be carried out before the calculation of attribute weights.
2.4 Introduction to Financial Early Warning Model
The main body of this paper is based on the genetic algorithm K-means. We use this model to categorize.
Besides, we use descriptive statistics and rough set to test results. Step as shown in figure 1:
508

Update the center of

K-means clustering
No

Code chromosome Select crossover,

K-means Iterative number
Generate initial population genetic, mutation
clustering =100？
Yes End
Select the fitness function operator

Comparison
Select data
Start Data preprocess
Identify the degree of
coincidence

Descriptive statistics Rough set test

Figure 1: The Principle of Financial Early Warning Model

3 Simulation Experiment and Result Analysis

3.1 Data Selection
If we want predict the monthly sales and get the better results, we need to find out the similar historical month
(1) Selection of sample firms. Most of the specially treated company have financial crisis and encounter
serious difficulty in its business management. Based on the previous study experience, we define those
companies suffered special treatment as the financial distress companies. This paper selects 24 A-share
companies listed in Shanghai Stock Exchange and Shenzhen Stock Exchange as the research object. Among
them, there are 12 special treatment companies. At the same time, based on selection criteria of similar
industry and similar asset size, this paper selects 12 normal financial companies as paired samples. In this
paper, the empirical data are derived from “www.cninfo.com.cn/”. (Table 1)

Table 1: Sample Companies

Number（ST*） Stock symbol Number Stock symbol
1 000033 13 600593
2 000059 14 600123
3 600444 15 600060
4 000068 16 300118
5 000155 17 002654
6 000510 18 300446
7 000557 19 300429
8 000590 20 000813
9 000611 21 002144
10 000659 22 002374
11 000677 23 603919
12 000799 24 600519

(2) Selection of financial index. The financial crisis is symptomatic, and can be predicted by a series of
observable financial indicators. Whether the financial early-warning indexes are reasonable, it will determine
the accuracy of the financial early-warning model. This paper makes full use of previous research in financial
warning index selection, initially selects 28 indicators as an alternative to evaluate variables. They are Current
Ratio (X1), Quick Ratio (X2), Asset-liability Ratio(X3), Interest Coverage Ratio(X4), Profit Rate to Net
Worth(X5), Gross Margins on Sales(X6), Net Profit Margin on Sales(X7), Earning Per Share(EPS) (X8),
Receivables Turnover Ratio(X9), Inventory Turnover(X10), Current Assets Turnover(X11), Total Assets
Turnover(X12), Net Asset Growth Ratio(X13), Net Profit Growth Ratio(X14), Main Business Income Growth
Rate(X15), operating profit growth rate(X16), total profit growth rate(X17), total asset growth(X18), main profit
growth rate(X19), cash flow growth rate per share(X20), growth rate of net assets per share(X21), growth rate
of earnings per share(X22), ratio of asset inflation proof and incremental value(X23), Ratio of retained
earnings to total assets(X24), cash-flow rate(X25), Operating net cash flow per share(X26), fixed assets
ratio(X27), and intangible assets ratio(X28).
3.2 Data Classification
We need to classify 24 companies. However, due to the big sample data and the limited space, we only put
four companies’ financial data in our paper. These are two st* companies and two normal companies, as
shown in the following Table 2 which had pre-processed the defect data.
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Table 2: Financial data of companies

Type Symbol (st*)000659 (st*)000611 600519 603919
Debt-paying Ability X1 0.60 2.81 6.15 0.72
X2 0.47 2.77 4.27 0.38
X3 67.27 24.55 11.99 58.55
X4 126.63 -20,436.12 -58,594.82 1,033.92
Profitability X6 20.25 -4.20 92.61 60.1
X7 0.41 -141.32 53.01 14.02
X8 0.00 -0.07 6.91 0.79
Operational
X9 106.96 5,572.76 0.06 3.04
capacity
X10 3.49 2.46 0.11 1.60
X11 0.93 0.03 0.44 2.03
X12 0.29 0.02 0.23 0.69
Development ability X13 -5.43 -10.58 36.54 20.00
X14 -95.40 -442.98 9.13 32.95
X15 -20.66 -45.93 10.17 16.74
X18 -18.05 -4.28 31.00 18.97
Cash flow X25 10.92 12.35 56.61 31.37
Capital structure X27 0.59 0.06 0.14 0.37
X28 0.03 0.07 0.05 0.09

4. Empirical Study and Analysis

4.1 Indicators Screening
Although the primary indicators of financial early warning are very comprehensive, it may not be able to
sensitively forecast the Ltd financial situations. Too much of the early warning indexes not only become the
heavy workload, but increase the running time of model and affect the accuracy. Therefore, it is necessary for
us to further screening of indexes before the construction of early warning model. And there may be a strong
correlation between the indicators, which also affect the prediction result.
We use significant tests to screen. Effective early warning indicators should be at least show significant
differences between ST* companies and normal companies, so as to correctly judge the financial situation of
enterprises. In this paper, the indexes are significant analyzed to complete the screening by the Eviews
software. Besides, we remove the indexes which do not contribute to distinguish normal companies from
those companies in financial crisis. The results show that only indicators X1, X4, X8, X9, X11, X18, X25 pass
the significant test, the rest of indicators are excluded because they don’t pass the test of significance.
4.2 Test of Rough
Step 1: Weight calculation. We use the formula of rough set theory to calculate the weight of the 7 financial
indexes.

Si g c 
Wo c   (4)
 Si g  
C

Step 2: Comprehensive score for each company. We get comprehensive evaluation scores by
 Ci  W Ci .
Step 3: Test. In order to further test the correctness of clustering results, we use descriptive statistics and
variance analysis to analyze the comprehensive score of the companies in each category. The results are
shown in table 3.

Table 3: Descriptive statistics situation of the companies

Data Mean N Std. deviation
Class Ⅰ 0.170 8 0.058
Class Ⅱ 0.315 8 0.036
Class Ⅲ 0.412 8 0.072
Total 0.299 24 0.166
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4.3 Result analysis

According to the above test, we find that the average is on the upward trend from the first to the third category.
It shows that the average score is significant difference between the different categories. The mean errors of
the first class, the second class and the third class are small. It shows that different is small within the groups
and the companies within each group are similar. There are three companies which are not consistent with the
experimental results. We obtain the conclusion that the accuracy of the model is 87.5%.

5. Conclusion
At present, there are a lot of models in the field of financial early warning research, how to choose the
appropriate early warning methods play a key role in the validity and accuracy of the warning. In this paper,
we find that the K-means clustering algorithm based on genetic algorithm is more accurate than the traditional
clustering algorithm. The results of this study provide a new idea for the company classification and a good
way of financial warning. It provides an effective basis for the relevant personnel to forecast the financial crisis
of enterprises. For protecting the interests of investors and creditors, helping the management departments to
monitor listing Corporation quality and avoiding the risk of the securities market, it also has important practical
significance.

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