CORPORATE FINANCIAL DISTRESS PREDICTION USING STATISTICAL EXTREME VALUE-BASED MODELING AND MACHINE LEARNING

Abstract

The industrial sector plays a leading role in an economy such that the financial stability of companies from this sector be a big concern. Two financial ratios, i.e., the Interest Coverage Ratio (ICR) and the Return on Assets (ROA), are used to determine the corporate financial distress conditions. This work considers two schemes for determining financial distress. First, a company is categorized as distressed if either ICR<1 or ROA<0. The second scheme is for when both ICR<1 and ROA<0 are met. The proportion of distressed and non-distressed companies is imbalanced. Our work views the distressed companies (minority class) as a rare event, causing the proportion to be extremely small, such that the Extreme Value Theory can be employed. The so-called Generalized Extreme Value regression (GEVR), developed from GEV distribution, predicts the distressed labels. The GEVR's performance is compared using machine learning with and without feature selection. The feature selection in GEVR uses backward elimination. The model for prediction employs a drift or windowing concept, i.e., using past-period predictors to predict the current response. The empirical results found that the GEVR, with and without the feature selection, provides the best prediction for financial distress.