The Analysis and Use of Financial Ratios: A Review Article

Abstract

Financial ratios are used for all kinds of purposes. These include the assessment of the ability of a firm to pay its debts, the evaluation of business and managerial success and even the statutory regulation of a firm's performance. Not surprisingly they become norms and actually affect performance.' The traditional textbooks of financial analysis also emphasise the need for a firm to use industry-wide averages as targets (Foulke, 1968), and there is evidence that firms do adjust their financial ratios to such targets.* Whittington (1980) identified two principal uses of financial ratios. The traditional, normative use of the measurement of a firm's ratio compared with a standard, and the positive use in estimating empirical relationships, usually for predictive purposes. The former dates back to the late nineteenth century and the increase in US bank credit given as a result of the Civil War when current and non-current items were segregated and the ratio of current assets to current liabilities was developed (Horrigan, 1968;and Dev, 1974). From then the use of ratios both for credit purposes and managerial analysis, focusing on profitability measures soon began. Around 1919 the du Pont Company began to use its famous ratio 'triangle' system to evaluate its operating results, underpinning the modern interfirm comparison scheme introduced in the UK by the British Institute of Management and the British Productivity Council in 1959.The positive use of financial ratios has been of two types: by accountants and analysts to forecast future financial variables, e. g. estimated future profit by multiplying predicted sales by the profit margin (the profit/sales ratio), and, more recently, by researchers in statistical models for mainly predictive purposes such as corporate failure, credit rating, the assessment of risk, and the testing of economic hypotheses in which inputs are financial ratios. These will be reviewed in the section on predictive studies.The reason ratios are used, as opposed to absolute values, is a mathematical one, and is basically in order to facilitate comparison by adjusting for size. However, this assumes that ratios possess the appropriate statistical properties for handling and summarising the data. Also, the statistical models assume,

Distributional Properties of Some Financial Ratios in Insurance

“…The first argument as to why ratios may not be normally distributed, even after outlier removal, is because they tend to violate what is known in the literature as the proportionality assumption (Whittington, 1980;Barnes, 1987;Fieldsend, Longford, & Mcleay, 1987). Summarising this assumption briefly, a ratio defined as y/x controls for the effect of the size variable x, but only if the relationship y = bx holds.…”

Have changes in business practices and reporting standards changed the taxonomy of financial ratios?

“…It seems probable that the fundamental relationships underlying the taxonomy have been impacted by these changes, and continued reliance on the taxonomy is unwarranted if its structure has become unstable (Altman and Eisenbeis, 1978;Barnes, 1987).…”

Exploring the Relationship between Financial Ratios and Market Stock Returns

“…Barnes (1987) explores the actual relationship between financial ratios and stock returns since ratios are perceived as helpful in predicting future rates of returns. Beaver (1966) argue that financial ratios are generally used as inputs to predict a number of business related situations i.e., risk, financial distress, future cash flows, and credit ratings, and, among others.…”