Mirjana Peji Bach

Faculty of Economics & Business Zagreb, Croatia

mpejic@efzg.hr

Sandro Jukovi
Erste&Steiermrkische Bank
sjukovic@gmail.com

Jasmina Pivar
Faculty of Economics & Business Zagreb, Croatia
jpivar@efzg.hr

Marijana Ivanov
Faculty of Economics & Business Zagreb, Croatia
mivanov@efzg.hr

Boidar Jakovi
Faculty of Economics & Business Zagreb, Croatia
bjakovic@efzg.hr

Cluster analysis approach to the financial

instability discovery
Abstract
Cluster analysis has been used for the purpose of the decision-making support in the
beginning of the 70s, when several authors have analysed the companies quoted on the
New York Stock Exchange, according to their profit and dividends. Some researchers have
used the method for the identification of the stocks that could be utilized for the portfolio
diversification while retaining the profitability at the same time. The goal of this paper is to
compare the application of Z-score, Kralicek DF indicator and a GCE3 indicator of the
financial stability of the companies that are quoted on the Zagreb Stock Exchange using data
from 2009. Ratios used for the generation of selected financial stability indicators were used
for the cluster analysis using the SOM-Ward algorithm. For that purpose, Viscovery software
was used. Cluster analysis is applied in this paper using self-organizing maps that was
developed by the Tuevo Kohonen in 80s, taking into account that the main advantage of this
method is automated clustering and visualisation capability, which will be presented in the
paper. Results revealed that analysis indicated the smallest number of unstable companies
using GCE3 indicator (15% unstable companies), followed by the Kralicek DF indicator (24%
of unstable companies), and Z-score (37% of unstable companies). Since we have
conducted our analysis based on the data from 2009, our next goal is to compare what really
happened after the five years (in 2014) with the examined companies.

Keywords: cluster analysis, SOM-Ward, Viscovery, financial instability, Zagreb Stock

Exchange

1 Introduction
Cluster analysis has been used in financial decision-making since the beginning of 70s when
companies listed on the New York Stock Exchange (NYSE) were analyzed by several
authors, according to their profits and dividends (Romesburg, 2004). Some researchers have
used this method for the identification of the stocks that could be utilized for the portfolio
diversification while retaining the profitability at the same time. Therefore, earlier studies
showed that the cluster analysis is a suitable technique to obtain information for decision
making.

Defining the important variables, that are used in clustering data, is necessary for cluster
analysis. In that purpose, Z score model has been developed on the example of American
companies by Altman in 1968. Some other empirical studies have elaborated this issue as
well. One of those studies was Croatian study in which GCE3 was developed (Zenzerovi,
2009). After defining the important variables, it was possible to perform the cluster analysis
using standard methods of clustering (k-means, hierarchical clustering, and so on). In this
work, cluster analysis will be carried out by the method of the self-organizing maps,
developed by Teuvo Kohonen in the '80s of the last century (Kohonen, 1995). The main
advantages of these methods are the automatic clustering and visualization capabilities.

The goal of this paper is to carry out a comparative analysis of the financial stability of
companies listed on the Zagreb Stock Exchange using data from 2009. The analysis is
based on the following indicators: Z score, Kralicek DF and GCE3 and is performed by
Viscovery SOM software that enables SOM Ward clustering algorithm (Viscovery, 2009).
Furthermore, we will perform the comparison of what really happened with the examined
companies using the data from 2014.

In this paper, selforganizing maps (SOM) and the algorithm used for the analysis are
presented. Then, financial indicators that are utilized in this work are introduced. The paper
describes the research methods and the data employed in this work. Then it discusses the
results of our work, and the conclusion summarizes the results of the analysis.

2 Methodology
This section provides the introduction to SOM and Ward clustering, along with the SOM
Ward algorithm. Also, synthetic indicators of financial stability and data used in the
calculation of these indicators are described here.

2.1 Self-organizing maps and Ward clustering

SOM are based on the concept of neural networks and can be defined as a twolayer neural
network. Neural networks are the models of the biological neural networks of the human
nervous system. It is a set of parallel interconnected neurons that are organized in layers.
Each connection between neurons input output layer has its corresponding weight
(Huysmans, Baesens, Vanthienen, van Gestel, 2006). Applications of the neural networks
are numerous. For instance, they are used in the financial services industry (Kumar, Ravi,
2007).

The classical Ward cluster method belongs to the agglomerative clustering algorithm. It will
start with n cluster of size 1. That means that each unit (node) forms a cluster. In each step
of the algorithm, the two clusters with minimal distance are merged according to a distance
measure defined for the specific algorithm. This minimal distance is called distance niveau of
the step. The goal of Ward cluster algorithm is to minimize the variance within each cluster
and to maximize the variance between the clusters (Viscovery, 2009).
2.2 SOM-Ward algorithm in Viscovery SOMine
Viscovery SOMine is a software tool used for Clustering and Data Visualization (Viscovery,
2009). The tool has three inbuilt algorithms: SOM Single-linkage, SOM-Ward algorithm, and
Ward algorithm. The SOM-Ward algorithm is used in this paper and, therefore, should be
explained thoroughly.

The SOM-Ward algorithm is a so-called hybrid algorithm that was developed on the grounds
of the soft computing paradigm. It is a computing paradigm that is primarily based on the
usage of various intelligent methods and algorithms, as opposed to the hard computing
paradigm. Soft computing starts from the comprehension that these methods are rather
complementary than competitive in terms of technology characteristics like efficiency,
tolerance to errors/inaccuracies and learning from examples. Hybrid algorithms that are a
result out of this mindset have minimized the deficiencies and maximized the advantages of
individual technologies that were used in their construction (Kumar, Ravi, 2007). Simply said,
synergy effects of data analysis tools, like better efficiency, precision and ability to learn are
possible due to the hybridization of various methods.

In SOMine, the distance matrix is initialized with respect to the number of data records that
are represented by nodes on the output map. The nodes with many corresponding data
records have a higher ponder than the nodes that have fewer connections.The distance
measure used in this algorithm is modified Ward distance because it is very likely that a map
would contain empty nodes (Viscovery, 2009).

2.3 The Synthetic indicators of financial stability

In this subsection, synthetic indicators that are used in our work and will be described are
following: Revised Z Score (A Model), Kralicek DF indicator, and GoingConcernEstimation
(GCE3) indicator.

Altman Z score indicator was developed in 1968 based on a sample composed of 66

American companies divided into two groups, with 33 companies in each group. The data
collected refer to the period from 1945 to 1965. A list of 22 variables (ratios), classified into
liquidity, profitability, leverage, solvency, and activity ratio categories was compiled for
evaluation. Using multiple discriminant analysis (MDA), five of the variables were selected as
doing the best overall job together in the prediction of companies bankruptcy. Description of
variable selection and variables itself can be found in Altman (2000). However, we use
revised Z score (A model) for the purpose of our work. Revised Z score A model uses the
book value of equity instead of the market value. Thus, companies that are not listed on the
stock exchange, but are significant for the analysis, can be included in the model.
Table 1. shows the values of Altman Z score.

Table 1: Altman Z score: Critical values (ager, K., Mami Saer, Sever, ager, L., 2008,
p. 272)

Score range (from -4.0 to +8.0) - bancruptcy risk

Z - score model "Grey" Zone = 1
Very Low = 0 Very High = 2
Concern Within two years
Model A 2.9 2.89 - 2.69 2.68 - 1.24 1.23

Kralicek DF indicator was derived on the basis of data from financial statements of German,
Swiss and Austrian companies. It is based on six variables selected by using MDA as
described by Zenzerovi and Peruko (2006). For a purpose of our work, the companies are
classified into two categories. The company was identified as financially unstable if its
Kralicek DF value was less than 0.3, and financially stable if indicator value was above of
0.3. Critical values of Kralicek DF indicator with the corresponding stability assessment are
shown in Table 2.

Table 2: Kralicek DF: Critical values with the corresponding financial stability assessment
(adjusted according to ager, K., Mami Saer, Sever, ager, L., 2008, p. 273)

Kralicek
Financial stability Risk of bankruptcy - Category
DF value
3.0 Excellent
2.2 Very good
Low Risk = 0 (financially stable
1.5 Good company)
1.0 Average
0.3 Bad
0.3 Beginning of the insolvency
High Risk = 1(financially unstable
0.0 Moderate insolvency company)
-1.0 Strong insolvency

Some researchers have found that the application of the models derived using the data on
companies in developed countries does not obtain the same results when they are applied in
transitional countries. GCE3 model is specific because of its suitability for the transitional
environment. It is the result of empirical research performed on the sample data on Croatian
companies. The GCE3 indicator was developed by using MDA and includes six variables as
explained by Zenzerovi (2009). Table 3. shows critical values of the GCE3 indicator.

Table 3: Critical values of GCE3 indicator (adjusted according to Zenzerovi, 2009)

GCE3 value Risk of bankruptcy - Category

0.000019 Low Risk = 0 (financially stable company)
0.000019 High Risk = 1(financially unstable company)

2.4 Data and approach

Our research was conducted on a sample of companies listed on the Zagreb Stock
Exchange. Data were collected from the Zagreb Stock Exchange website and official
financial reports of companies. The data collection is based on the similar models found in
the existing literature. Simonoff (2003) performed a similar type of comparison over the
Japanese and Korean companies. The analysis of the financial environment of Finnish
companies was provided by Lansiluoto and Eklund (2008). The population size is 241 and
the sample consists of 62 Croatian companies whose shares were traded significantly in a
period from 2008 to 2010, excluding companies in the financial sector. Data were collected
from the financial statements of the companies from 2009.

Synthetic indicators were calculated based on the individual indicators and calculation was
conducted using MS Excel. For that purpose, we created the database that comprises the
data on 23 variables divided into three groups: i) the variables that were used to perform
SOM clustering based on the Z score are Working Capital/Total Assets (WC/TA), Retained
Earnings/Total Assets (RE/TA), Earnings Before Interest and Taxes/Total Assets (EBIT/TA),
Book Value of Equity/Total Liabilities (BV/DEBT), Total Sales Revenues/Total Assets
(SALE/TA), Z-score and Risk estimated according to Z- score; ii) the variables that were
used to perform SOM clustering based on the Kralicek DF variables are Earnings Before
Interest and Taxes/Total Assets (EBIT/TA), Total Sales Revenues/Total Assets (SALE/TA),
Net Cash Flow/Total Liabilities (CF/DEBT), Total Assets/Total Liabilities (TA/DEBT),
Earnings Before Interest and Taxes/Total Revenue (EBIT/TR), Inventory/Total Revenue
(TS/TR), Kralicek DF and Risk estimated according to Kralicek DF; iii) the variables that were
used to perform SOM clustering based on the GCE3 are Working Capital/Total Assets
(WC/TA), Total Liabilities/Total Assets (DEBT/TA), Book Value of Equity/Total Assets
(BV/TA), Total Liabilities/(Book Value of Equity+Depreciation) (DEBT/(BV+DEPRECIATION),
Book Value of Equity/Total Assets (BV/TA), Total Revenue/Total Expenditure (TR/TE), GCE3
and Risk estimated according to GCE3.

The variables' names have been chosen on the basis of research on the efficiency of
supervised and unsupervised neural networks in the case of Korean companies (Lee, Booth,
Pervaiz, 2005). The company was identified as the financially unstable (close to bankruptcy)
according to the critical values for each synthetic indicator.

Data were analyzed with SOMine software tools (version 5.1), and clustering was performed
by using combined SOM-Ward algorithm that was developed by Viscovery (Viscovery, 2009).
Three cluster analyzes were developed using an SOM-Ward algorithm with the following
input data presented in Table 4.

Table 4: Data used for the cluster analysis (authors)

Cluster analysis approach Indicators used

WC/TA
RE/TA
EBIT/TA
SOM clustering based on the Z-score BV/DEBT
SALE/TA
Z-score
Risk estimated according to Z-score
EBIT/TA
SALE/TA
CF/DEBT
TA/DEBT
SOM clustering based on the Kralicek DF
EBIT/TR
TS/TR
Kralicek DF
Risk estimated according to Kralicek DF
WC/TA
DEBT/TA
BV/TA
DEBT/(BV+DEPRECIATION)
SOM clustering based on the GCE3
BV/TA
TR/TE
GCE3
Risk estimated according to GCE3

3 Results
Z score indicator and Kralicek DF indicator with their corresponding critical values reflect
the state of the companies objectively but are not derived on the basis of the sample data on
Croatian companies. On the other hand, GCE3 is developed on the basis of the data on
Croatian companies. Therefore, the main aim of this study is to examine if SOM clustering
based on the Z score, Kralicek DF, and GCE3 indicators can get the same clusters of the
companies (the comparative analysis of indicators), using clustering SOMine software tool.

3.1 SOM clustering based on the Z-score results

SOM clustering based on the Z score indicator differentiated three groups or clusters of the
companies depending on their financial stability. These clusters are following: (i) Low Risk
refers to the companies that are very stable; (ii) Medium Risk refers to the companies that
are moderately stable, and (iii) High Risk refers to the companies that are unstable

Figure 1 visually represents the clusters of the companies detected by the SOM-Ward
algorithm and presents the structure of the total sample according to the clusters. The black
line separates the clusters while color scale indicates the value of Z-score. As the value of Z
score indicator for a particular company is higher the color of each set of nodes is closer to
red color. Therefore, the maximum values of Z score indicator are marked with red color,
while the minimum values are marked in blue color. Each of three clusters has own
characteristics, and we can see how many companies in the sample are financially stable.
Cluster Medium risk contains 45.16%, Cluster High Risk 37.10% and Cluster Low Risk
contains only 17.74% of the total sample.

Figure 1: Z-score indicator Detected clusters (authors' calculation)

Using the Z score model, that is not adequately adapted to Croatian conditions, it can be
concluded that the most of the companies in the sample are very or moderately stable.

3.2 SOM clustering based on the Kralicek DF results

SOM clustering based on the Kralicek DF indicator has seven critical values that divide
companies into eight categories. For the purpose of this study, the critical value of 0,3 has
been chosen. This critical value divides companies into two groups. The company is marked
as financially stable if it has Kralicek DF lower than 0,3 and financially unstable if it has
Kralicek DF higher than 0,3. Therefore, Kralicek DF differentiated two groups of the
companies: Stable companies and Unstable companies.

The distribution of Kralicek DF indicator for the sample of the companies in our study is
shown in Figure 3. Minimal values of the Kralicek DF indicator are represented with blue
color. The color of each set of nodes is closer to a red color as the value of Kralicek DF
indicator for a particular company is higher. Stable companies are shown on the left side of
Figure 2. The clusters of the companies detected by the SOM-Ward algorithm that represent
stable companies are cluster Moderately secure and cluster Very safe that contain 76% of
the total sample. Also, 24% of the total sample is Bankruptcy risk companies which are 13
percentage points less compared to Z- score indicator. The reason is that the Kralicek DF
indicator is derived on the basis of the data on Middle European companies. Also, the Z
score indicator is derived on the basis of the data on American companies.

Figure 2: Kralicek DF indicator Detected clusters (authors calculation)

3.3 SOM clustering based on the GCE3 results

The distribution of SOM clustering based on the GCE3 indicator for the sample of the
companies in our study is shown in Figure 3. GoingConcernEstimation3 (GCE3) indicator has
only one critical value that divides companies into Stable companies and Unstable
companies. The percentage of the financially unstable companies in the total sample is 15%
which is nine percentage points less compared to Kralicek DF. Also, the percentage of
financially unstable companies decreased from the initial 37,10% with the Z score indicator
to 15% when companies are observed with the GCE3 indicator. Furthermore, the percentage
of financially stable companies is 85%. However, the SOM clustering based on the GCE3
approach has also detected four clusters: Very secure companies, Moderately secure
companies, Insecure companies and Bankruptcy risk companies.

Figure 3: GCE3 indicator Detected clusters (authors' calculation)

4 Discussion
Since we have conducted our analysis based on the data from 2009, we have a chance to
compare what really happened after the five years with the examined companies. Table 5
provides the outlook of the financial or legal status of examined companies based on the
data obtained from Croatian Financial Agency (FINA). The results revealed that most of the
companies (64,52%) are still well functioning and in 2014 these companies were profitable.
There are less companies that were in the loss in 2014 (24,19%), and the smallest number of
companies went bankruptcy (6,45%). Three companies were merged or acquired, and these
were not taken into account for further analysis. Therefore, further analysis will be conducted
based on the 59 firms. For the purpose of our analysis, the profitable firms were coded as the
lowest level of risk, the firms with the loss were coded as the middle level of risk, and the
firms that went bankruptcy were coded as the highest level of risk.

Table 5: Financial or legal status of examined companies in 2014 (authors calculation)

Financial or legal status Estimated level of risk Frequency Percent

Profit Lowest 40 64,52
Loss Middle 15 24,19
Bankruptcy Highest 4 6,45
Merging / Acquision N/A 3 4,84
Total 62 100

Table 6 provides the synthetic presentation of the risks forecasts of used clustering methods.
Following coded was conducted. Z-score values of Low Risk, Medium Risk, and High Risk
were coded as the Lowest, Middle, and Highest respectively. Kralicek values of Very safe,
Moderately secure and Bankruptcy risk were coded as the Lowest, Middle and Highest
respectively. Finally, GCE3 values of Very secure, Moderately secure were coded as the
Lowest and Middle level of risk, while Insecure and Bankruptcy companies were coded as
the Lowest level of risk. Using this approach, we managed to be able to compare the actual
financial and legal status of examined companies with the clustering forecasts.

Table 6 presents the risks forecasts of clustering methods, and it reveals that the SOM
clustering based on the GCE3 approach forecasted the highest percentage of companies as
the Lowest level of risks, while on the other hand SOM clustering based on Kralicek
approach forecasted the highest percentage of companies as the Highest level of risks.
Finally, SOM clustering based on the Z-score approach forecasted the highest percentage of
companies with the Middle level of risks.

Table 6: Risks forecasts of SOM clustering approaches

SOM clustering based on the

Estimated level of risk GCE3 Kralicek DF Z-score
Frequency Percent Frequency Percent Frequency Percent
Lowest 25 42,37 14 23,73 22 37,29
Middle 22 37,29 27 45,76 27 45,76
Highest 12 20,34 18 30,51 10 16,95
Total 59 100,00 59 100,00 59 100,00
Table 7 provides the comparison between the actual level of risks observed in 2014 with the
forecasts of the SOM clustering based on the GCE3, Kralicek DF, and Z-score approach. In
2014, there were only four companies that went bankruptcy (with the Highest risks). SOM
clustering based on the GCE3 approach forecasted that 3 companies will go bankruptcy, as
well as Z-score, while Kralicek forecasted only two such companies. On the other hand, 40
companies were profitable in 2014, and GCE3 approach forecasted only 10 such companies,
Kralicek forecasted 15 such companies and Z-score only eight such companies. In total,
SOM clustering based on Kralicek was the most successful, with the 33,78% of total correct
forecasts, while the SOM clustering based on the GCE3 approach was the least successful.

Table 7: Number of companies according to the forecasted and actual risk (author's
calculation)

SOM 2014 / Actual level of risk

clustering Forecasted level of Total correct % of total
based on risk Highest Middle Lowest forecast correct
the forecasts
Highest 3 8 14
GCE3 Middle 1 5 16 18 29,03%
Lowest 0 2 10
Highest 2 7 5
Kralicek
Middle 1 6 20 23 37,10%
DF
Lowest 1 2 15
Highest 3 5 14
Z-score Middle 0 9 18 21 33,78%
Lowest 1 1 8

5 Conclusion
This paper presents the comparative analysis of the financial stability of the companies that
were listed on the Zagreb Stock Exchange in 2008. The sample size is 62. Our research
showed that 37% of the companies are classified as financially unstable using SOM
clustering based on the Z score approach, 24% of the companies are classified as
financially unstable using SOM clustering based on the Kralicek DF and 15% of the
companies are classified as financially unstable using SOM clustering based on the GCE3.

The results differ due to the fact that each indicator is developed on the basis of the different
sample data: Z-score indicator using data on US companies, Kralicek DF using data on
Central European companies and GCE3 using data on Croatian companies. It is shown that
22% (37% - 15%) of the Croatian companies that were classified as stable would be at risk of
bankruptcy if they would operate in the USA. Similarly, the 9% of the Croatian companies
that were classified as stable would be at risk of bankruptcy if they would operate in Central
Europe.

However, when the forecasts were compared with the actual financial and legal status
observed after five years (in 2014), it was revealed that the SOM clustering based on the
Kralicek DF was the most successful with the total of 37,10% of correct forecasts. On the
other hand, SOM clustering based on the GCE3 was the least successful with the total of
29,03% of correct forecasts.
Although the forecasting accuracy of the SOM clustering was not high in the total forecasts
accuracy, it was on the other hand quite successful in the forecasting bankruptcy. Among the
four firms that went bankruptcy, the SOM clustering approach based on the GCE3 and Z-
score correctly forecasted three firms. Therefore, the usage of SOM clustering approach
using GCE3, Z-score, and Kralicek DF has potential for the future usage, but further refining
in terms of algorithms and input data should be taken into account. In the future research, the
number of companies in the sample should be increased in accordance with the number of
the companies used to derive GCE3 indicator (Zenzerovi, 2009).

Various economic subjects, especially shareholders and investors who want to diversify their
portfolio, can use the findings of this work. For example, they may decide to invest in the
companies that are in the same clusters as the best company. This way they would reduce
the risk and profits would remain within the tolerance limits they chose.

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