This chapter aims to dynamically improve the method of predicting financial distress based on Kalman filtering. Financial distress prediction (FDP) is an important study area of corporate finance. The widely used discriminant models currently for financial distress prediction have deficiencies in dynamics. Based on the state-space method, we establish two models that are used to describe the dynamic process and discriminant rules of financial distress, respectively, that is, a process model and a discriminant model. These two models collectively are called dynamic prediction models for financial distress. The operation of the dynamic prediction is achieved by Kalman filtering algorithm, and further, a general n-step-ahead prediction algorithm based on Kalman filtering is derived for prospective prediction. We also conduct an empirical study for China’s manufacturing industry, and the results have proved the accuracy and advance of predicting financial distress in such case.
Part of the book: Kalman Filters