Financial Distress Prediction Models: A Review of Their Usefulness 1

Throughout the 1980s there has been continued interest in developing financial distress prediction models for both large and small firms. There has, however, been no survey of this literature directed towards assessing the uses and limitations of these models in a management context. The purpose of the paper is, therefore, to indicate the managerial uses and limitations associated with adopting financial distress prediction models. The paper achieves this end by considering in section two the current financial distress prediction techniques and their limitations. Section three examines the relevance of the predicted event (usually actual failure), the usefulness of multi-outcome models and the appropriateness of various sample selection methods. A review of the range and adequacy of the financial and non-financial information used to construct predictive models forms the basis of the fourth section and is followed in section five by a review of the validity of the claims made on behalf of their predictive accuracy. The following section examines the efficacy of other methods of predicting distress, and reviews the 'man versus model' literature concerning the relative abilities of unaided human decision-makers and statistical models. The final section offers conclusions and suggests where future work might be directed.