The limitations of bankruptcy prediction models: Some cautions for the researcher

The purpose of this study is to demonstrate potential problems associated with the use of bankruptcy prediction models in current research. The tests in this study demonstrate the problems that may arise when bankruptcy prediction models are inappropriately applied. This analysis evaluated the Zmijewski (1984) and Ohlson (1980) models using time periods, industries, and financial distress situations other than those used to originally develop the models. The findings indicated that both models were sensitive to time periods. That is, the accuracy of the models declined when applied to time periods different from those used to develop the models. The findings also suggest that the accuracy of each model continues to decline moving from the 1988-1991 to the 1992-1999 sample period. Additionally, Ohlson's (Zmijewski's) model was (was not) sensitive to industry classifications. The findings of this study also suggest that the Ohlson and Zmijewski models are not sensitive to financial distress situations other than those used to develop the models. Thus, the models appear to be more generally useful for predicting financial distress, not just bankruptcy. In sum, the results of this study suggest that researchers should use bankruptcy prediction models cautiously. Applying the models to time periods and industries other than those used to develop the models may result in a significant decline in the models' accuracies. Additionally, some bankruptcy prediction models may be more appropriate for evaluating various forms of financial distress as opposed to just bankruptcy. To avoid erroneous applications of bankruptcy prediction models in the future, it is necessary for researchers not only to understand the uses of prediction models, but also to understand the limitations of the models.