4. SUMMARY

Financial statement analysis has long traditions. Through the decades practitioners and researchers have come up with a vast number of financial ratios to be used in the evaluation of the performance and financial status of business firms. Much research has been done to reduce the obvious redundancy between the financial ratios by classifying them and selecting one or two representative financial ratios from each group. This facilitates essential reductions in the number of the potential financial ratios, without any marked loss of information content in the financial statement analysis results.

The research classifying the financial ratios can be divided into three main approaches. The pragmatic approach is largely based on the common business practices of financial statement analysis. The inductive approach is primarily based on observed statistical behavior of financial ratios. Finally, the deductive approach draws from theoretical considerations and the empirical properties of the financial ratios. Our study best belongs to the third approach.

Our study covered three different types of financial ratios, the accrual ratios, the cash flow ratios, and the market-based ratios. Research categorizing financial ratios has traditionally concentrated on accrual based figures, and the research involving cash flow ratios in the categorization has been more scanty. Market-based ratios have practically been lacking from the earlier studies.

We used factor analysis and transformation analysis as our statistical methods. The former has traditionally been applied to classifying the financial ratios. The latter method was used to test the temporal stability of the financial ratio factors. The use of transformation analysis methodology in financial ratio categorization has few precedents, and can be considered a novel technique in this field.

We used a hypothesis testing approach in our study. Four central hypotheses based on finance and accounting theories, and earlier research, were presented and tested. The hypotheses were called the return and risk categorization hypothesis of market-based ratios, the performance and financial standing dichotomy hypothesis of accrual ratios, the cash flow information hypothesis, and the hypothesis on the viability of standard financial ratio classifications. The content of these hypotheses was the following.

Six stable factors of financial ratio information could be identified by factor and transformation analyses from our data of 32 publicly traded Finnish companies for 1974-84. Stability means that the content of the factors remains reasonably unchanged when the results of the first half and the second half of the observation period are compared with the transformation analysis. The stable factors were a profitability factor, an operational leverage factor, a cash flow factor, a size & beta factor, a dynamic liquidity factor, and a growth rate factor.

The first hypothesis, stating that the market-based ratios would load on a common factor of return and riskiness, was not confirmed. In fact, the market-based ratios dispersed widely on different factors. Even if unexpected, this result may reflect the low explanatory power of market models such the Capital Asset Pricing Model. This result also means that the development of market-based ratios is either still at an infant stage, and / or that unlike the accrual and cash flow financial ratios the market-based ratios simply are not amenable to a consistent categorization.

It is also interesting to see that the firm size variable and the market-based beta made up a stable factor of their own. This result strongly supports the earlier research results on the interdependence of firm sizes and security betas.

The second hypothesis stated that business firms are characterized by two underlying main features, that is their dynamic performance and static financial standing. The observed accrual-related stable factors included the profitability factor and the operational leverage factor. The identification and interpretation of the profitability factor was very straight-forward, but the operational leverage factor was more difficult to interpret. These results lend reasonable support, but should be take with some caution because of the problems in interpreting the content of the operating leverage factor.

The third hypothesis stating that cash flow ratios would load on a separate and distinct stable factor was strongly confirmed. This corroborates earlier results that cash flow ratios impart information not present in the accrual-based financial ratios.

The fourth hypothesis concerned the standard text-book financial ratio classification into profitability, liquidity, solvency, and turnover. Our results did not lend direct support to this conventional classification, but the here the results must be considered inconclusive.

The empirical results also gave rise to observing that the defensive interval measure and the accounts receivable made up a strongly stable factor, which we named a dynamic liquidity factor. Finally, growth and operating margin formed a distinct and stable growth factor. This factor emphasizes the importance of growth estimates in financial statement analysis.


Goto: The next section (References)
Goto: The previous section (3. Empirical Results and Interpretation)
Goto: The contents section of Salmi, Virtanen and Yli-Olli (1990)
Goto: Other scientific publications by Timo Salmi in WWW format

Departments of Accounting and Mathematics, University of Vaasa,
Finland

itv@uwasa.fi
pyo@uwasa.fi
[ts@uwasa.fi] [Photo] [Programs] [Research] [Lectures] [Department] [Faculty] [University]