3. EMPIRICAL RESULTS AND INTERPRETATION
3.3 Other Observed Stable Factors
In the previous section we looked at the effect of the emerging stable factors and their influence on our hypotheses. As we saw, the first one was rejected, the second and the third one supported, and for the fourth the results were not clear-cut.
In addition to the stable profitability, leverage, and cash flow factors three other stable factors were found. These are the size & beta factor, the dynamic liquidity factor, and the growth rate factor.
3.3.1 Size & Beta Factor
The relative size of the firm and its market-based beta (size and security's beta) load on the same stable factor, as can be seen from appendices C, D, E, and F. The coefficient of coincidence between the two sub-periods for the size & beta factor is a high 0.908 which indicates a strong stability of this factor.
Admittedly, we did not hypothesize the emergence of the size & beta factor, but with the benefit of hindsight the appearance of this factor is not surprising.
Increasing attention has been drawn in finance research to the existence of
persistent anomalies from market efficiency. Among these anomalies feature e.g.
the monday-effect anomaly, the january-effect anomaly, the price-to-earnings ratio anomaly and the concomitant "size-beta" anomaly. Basu (1983: 142) observed for a Compustat sample covering 1962 - 1978 that the betas (systematic risk) of the common stock of NYSE firms "decline quite dramatically and in a monotonic way as one moves from portfolios consisting of small firms to those consisting of the larger ones".
3.3.2 Dynamic Liquidity Factor
The defensive interval measure and the accounts receivable turnover period load on the same factor, and they are the only ratios in the factor. This factor got the highest coefficient of coincidence between the two sub-periods (0.912). This indicates a strong stability of the factor.
The defensive interval measure has traditionally been considered a measure of short-term liquidity. (See e.g. Sorter & Benston 1960, Davidson & Sorter & Kalle 1964, and Fadel & Parkinson 1978.) As discussed in introducing the ratios at the early stages of this report, the defensive interval measure is a balance sheet / income statement ratio. Liquidity ratios which include an income statement element are often called dynamic ratios. We shall consequently call this factor a dynamic liquidity factor.
As observed, the accounts receivable turnover period also loaded on the dynamic liquidity factor. And, as can be seen in Appendices B through D, the factor loadings of the two ratios have opposite signs. This is a natural result. It is to be expected that when the accounts receivable turnover period gets smaller (improves), the defensive interval measure grows (the liquidity improves). In managerial terms it could be said that an efficient control of accounts receivable improves liquidity.
The two ratios of the dynamic liquidity factor also have a definitional dependence, but as stated earlier, all such links cannot be avoided. Receivables
feature in both the ratios. (The current assets appearing in the defensive interval measure are made up by cash + marketable securities + accounts receivables.)
3.3.3 Growth Rate Factor
The growth factor is the last of our emerging six stable factors to be looked at. As seen in Appendix B growth and operating margin load on this factor. During the first sub-period the growth factor is made up by growth alone. During the latter sub-period operating margin and long-term liabilities load on the growth factor.
The emergence of a growth factor supports including growth measures in conventional financial statement analyses. According to our factor analysis results, growth measures produce information not necessarily present in the conventional X/Y-type financial ratios.
Growth and the generation of revenues (reflected in the operating margin) have a positive relationship. In other words fast growth and better than average revenue generating ability appear to be connected. This seems a sensible result. On the other hand, growth and profitability (measured e.g. by return on equity) did not go on the same factor in our study. At first sight this is somewhat baffling because of the evidence on a relationship between growth and profitability. (See e.g. Miller
& Modigliani 1966, Singh & Whittington 1968: Ch. 7., Eatwell 1971: 411, and Ruuhela & Salmi & Luoma & Laakkonen 1982: 340.) A closer look at the results in Appendix B for the entire period of observation shows, however, that the defensive interval measure, times interest earned, and return on equity do have significant factor loadings on the growth factor.
4. SUMMARY
Financial statement analysis has long traditions. Through the decades practi-tioners 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.
1) Market-based ratios will load on a factor of return and riskiness.
2) Factors of accrual-based performance and financial standing will be evident.
3) Cash flow ratios will load on a factor (or factors) of their own.
4) Factors of profitability, liquidity, solvency, and turnover will emerge.
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.
REFERENCES
Ahmavaara, Yrjö (1963). On the mathematical theory of transformation analysis.
Reports from the Social Research Institute of Alcohol Studies No. 1.
Aho, Teemu (1980). Empirical classification of financial ratios. Christer Carlsson, ed. Management Science in Finland (MASC 1980) Proceedings, 413-421.
Aho, Teemu (1981). Yrityksen tilinpäätösanalyysi. 3rd edition. Espoo: Otapaino, Otakustantamo.
Artto, Eero (1978). Money flow analysis. Journal of Business Finance &
Accounting 5:1, 27-37.
Baker, Kent H. & Gail E. Farrelly & Richard B. Edelman (1985). A survey of management views on dividend policy. Financial Management 14:3, 78-84.
Banz, R. (1981). The relationship between returns and market value of common stocks. Journal of Financial Economics 9:1, 3-18.
Barnes, Paul (1982). Methodological implications of non-normally distributed financial ratios. Journal of Business Finance & Accounting 9:1, 51-62.
Barnes, Paul (1983). Methodological implications of non-normally distributed financial ratios: A reply. Journal of Business Finance & Accounting 10:4, 691-693.
Barnes, Paul (1987). The analysis and use of financial ratios: A review article.
Journal of Business Finance & Accounting 14:4, 449-461.
Basu, Sanjoy (1983). The relationship between earnings' yield, market value and return for NYSE common stocks: Further evidence. Jounal of Financial Economics 12, 129-156.
Bayldon, R. & A. Woods & N. Zafiris (1984). A note on the 'pyramid' technique of financial ratio analysis of firms' performance. Journal of Business Finance
& Accounting 11:1, 99-106.
Bernstein, Leopold A. (1989). Financial Statement Analysis: Theory, Application, and Interpretation. Fourth Edition. Homewood, Illinois: Richard D. Irwin, Inc., 1. ed. 1974.
Black, F. (1972). Capital market equilibrium with restricted borrowing. Journal of Business 45:3, 444-455.
Black, F. & M. Jensen & M. Scholes (1972). The capital asset pricing model: Some empirical tests. M.C. Jensen, editor. Studies in the Theory of Capital Markets.
Blume, Marshall & Irwin Friend (1973). A new look at the capital asset pricing model. Journal of Finance 28:1, 19-34.
Bowen, R.M. & D. Burgstahler & L.A. Daley (1987). The incremental information content of accrual versus cash flows. The Accounting Review 62:4, 723-747.
Brealey, Richard & Stewart Myers (1984). Principles of Corporate Finance. Second Edition. Auckland, etc: McGraw-Hill.
Buckley, Peter J. & John H. Dunning & Robert D. Pearce (1984). An analysis of the growth and profitability of the world's largest firms 1972 to 1977. Kyklos 37:1, 3-26.
Chen, Kung H. & Thomas A. Shimerda (1981). An empirical analysis of useful financial ratios. Financial Management. Spring, 51-60.
Courtis, John K. (1978). Modelling a financial ratios categoric framework. Journal of Business Finance and Accounting 5:4, 371-386.
Cowen, Scott S. & Jeffrey A. Hoffer (1982). Usefulness of financial ratios in a single industry. Journal of Business Research 10:1, 103-118.
Davidson, Sidney & George H. Sorter & Hemu Kalle (1964). Measuring the defensive position of a firm. Financial Analyst's Journal 20, 23-29.
Dhrymes, P.J. & I. Friend & N.B. Gultegin (1984). A critical reexamination of the empirical evidence of the Arbitrage Pricing Theory. The Journal of Finance 39:2, 323-346.
Eatwell, John L. (1971) Growth, profitability and size: The empirical evidence.
Morris, Robin & Wood, Adrian, editors. The Corporate Economy:
Growth, Competition, and Innovative Potential, 389-412. Macmillan.
Elton, E.J. & M.J. Gruber (1987). Modern Portfolio Theory and Investment Analysis. New York: John Wiley & Sons.
Ezzamel, Mahmoud & J. Brodie & C. Mar-Molinero (1987). Financial patterns of UK manufacturing companies. Journal of Business Finance & Accounting 14:4, 519-536.
Fadel, Hisham & John M. Parkinson (1978) Liquidity evaluation by means of ratio analysis. Accounting and Business Research 30, 101-107.
Fieldsend, Susan & Nicholas Longford & Stuart McLeay (1987). Industry effects and the proportionality assumption in ratio analysis: A variance component analysis. Journal of Business Finance & Accounting 14:4, 497-517.
Foster, G. (1978). Asset pricing models: Further tests. Journal of Financial and Quantitative Analysis 13:1, 39-53.
Foster, George (1986). Financial Statement Analysis. Second edition. Englewood Cliffs, New Jersey: Prentice Hall, Inc.
Fridson, Martin S. & Michael J. Marocco (1986). Financial statement analysis.
Altman, Edward I. & Mary Jane McKinney, editors. Chapter 3: Handbook of Corporate Finance. John Wiley & Sons.
Friend, Irwin & Marshall Blume (1970). Measurement of portfolio performance under uncertainty. American Economic Review. September, 561-575.
Gombola, Michael J. & Edward Ketz (1983). A note on cash flow and classification patterns of financial ratios. The Accounting Review LVIII:1, 105-114.
Horrigan, James O. (1968). A short history of financial ratio analysis. The Accounting Review 43, 284-294.
Horrigan, James (1983). Methodological implications of non-normally distributed financial ratios: A comment. Journal of Business Finance & Accounting 10:4, 683-689.
Ismail, Badr E. & Moon K. Kim (1989). On the association of cash flow variables with market risk: Further evidence. The Accounting Review LXIV:1, 125-136.
Johnson, R.A. & D.W. Wichern (1982). Applied Multivariate Statistical Analysis.
Englewood Cliffs: Prentice Hall, Inc.
Johnson, Bruce (1979). The cross-sectional stability of financial ratio patterns.
Journal of Financial and Quantitative Analysis XIV:5, 1035-1049.
Kanto, Antti J. & Teppo Martikainen (1989). A confirmatory test of the validity of an a priori classification pattern of financial ratios. Proceedings of the University of Vaasa. Discussion Papers 99.
Kettunen, Pertti & Vesa Mäkinen & Kari Neilimo (1976). Tilinpäätösanalyysi.
Ekonomia-sarja 46. Espoo: Weilin+Göös.
Kinnunen, Juha (1988). The Time Series Properties of Accrual versus Cash-Based Income Variables: Empirical evidence from listed Finnish Firms. Doctoral Dissertation. The Helsinki School of Economics.
Laitinen, Erkki (1983). A multivariate model of the financial relationships in the firm. The Finnish Journal of Business Economics 32:4, 317-333.
Laitinen, Erkki K. (1988). Yrityksen talouden mittarit. Ekonomia-sarja.
Weilin+Göös.
Laurent C.R. (1979). Improving the efficiency and effectiveness of financial ratio analysis. Journal of Business Finance & Accounting 6:3, 401-413.
Lehtinen, Janne (1989). Yrityksen koon, iän ja toimialan vaikutus tunnuslukuihin.
Unpublished Master's Thesis in Accounting and Business Finance.
University of Vaasa.
Lev, Baruch (1974). Financial Statement Analysis: A New Approach. Englewood Cliffs, New Jersey: Prentice Hall, Inc.
Levy, Haim & Marshall Sarnat (1986). Capital Investment and Financial Decisions.
3rd edition. Englewood Cliffs, N.J., London, etc.: Prentice/Hall International.
Lintner, J. (1965). The valuation of risk assets and the selection of risky invest-ments in stock portfolios and capital budgets. The Review of Economics and Statistics 47:1, 13-37.
Lukkaroinen, Teija (1988). Yrityksen koon vaikutus tunnuslukuihin - perinteiset ja kassavirtaan perustuvat tunnusluvut. Unpublished Master's Thesis in Accounting and Business Finance. University of Vaasa.
Martikainen, Teppo (1989). Stock Price Behavior and Economic Operations of the Firm. Licentiate Dissertation in Accounting and Business Finance.
University of Vaasa.
Miller, M.H. & F. Modigliani (1966) Some estimates of the cost of capital to the electric utility industry 1954-57. American Economic Review 56:3, 333-348.
Mossin, J. (1966). Equilibrium in a capital market. Econometrica 34:4, 768-783.
Mustonen, Seppo (1966). Symmetric transformation analysis (in Finnish). Reports from the Social Research Institute of Alcohol Studies No. 24.
Perttunen, Jukka & Teppo Martikanen (1989). The functional specification of financial ratios. Proceedings of the University of Vaasa. Research Paper 142.
Pinches, George & A. Eubank & K. Mingo & K. Caruthers (1975). The hierarchical classification of financial ratios. Journal of Business Research 3:4, 295-310.
Pinches, George E. & Kent A. Mingo & J. Kent Caruthers (1973). The stability of financial patterns in industrial organizations. Journal of Finance 28, 389-396.
Pohlman, Randolph & Robert D. Hollinger (1981). Information redundancy in sets of financial ratios. Journal of Business Finance & Accounting 8:4, 511-528.
Rayburn, J. (1986). The association of operating cash flow and accruals with security returns. Supplement to the Journal of Accounting Research 24, 112-133.
Reinganum, M. (1981). Misspecification of capital asset pricing: Empirical anomalies based on earnings yield and market values. Journal of Financial Economics 9, 19-46.
Roll, R. (1977). A critique of the asset pricing theory's tests. Journal of Financial Economics 5:1, 129-176.
Ross, S.A. (1976). The Arbitrage Pricing Theory and Capital Asset Pricing. Journal of Economic Theory. December, 343-362.
Ruuhela, R. & T. Salmi & M. Luoma & A. Laakkonen (1982) Direct estimation of the internal rate of return from published financial statements. The Finnish Journal of Business Economics 31:4, 329-345.
Saario, Martti (1949). Kustannusten etuoikeusjärjestyksestä. Huugo Raninen 50 vuotta. Helsinki.
Salmi, Timo (1978). A comparative review of the Finnish expenditure-revenue accounting. European Institute for Advanced Studies in Management.
Working Paper 78-2.
Salmi, Timo & Martti Luoma (1981). Deriving the internal rate of return from the accountant's rate of profit: Analysis and empirical estimation. The Finnish Journal of Business Economics 30:1, 20-45.
Salmi, Timo & R. Dahlstedt & M. Luoma & A. Laakkonen (1986). Financial ratio variability and industry classification. The Finnish Journal of Business Economics 35:4, 333-356.
Sharpe, W.F. (1963). A simplified model for portfolio analysis. Management Science 9:1, 277-293.
Sharpe, W.F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance 19:3, 425-442.
Singh, A. & G. Whittington & H.T. Burley (1968). Growth, Profitability and Valuation. A Study of United Kingdom Quoted Companies Cambridge at the University Press.
Sorter, G.H. & George Benston (1960). Appraising the defensive position of a firm:
The interval measure. The Accounting Review 35:4, 69-76.
Sudarsanam, P.S. & L.H. Fortune (1987). Relative Usefulness of Accrual-based and Cashflow-based Earnings in Security Evaluation: An Empirical Test.
Presented at the EAA Annual Conference in Stuttgart 5-7 Apr.
Sänkiaho, Risto (1986). Temput ja kuinka ne tehdään. Monimuuttujamenetelmät kansan palvelijoina. Reports from the Institute of Educational Research 220/1974. University of Jyväskylä.
Virtanen, Ilkka & Paavo Yli-Olli (1989). Cross-sectional properties and time-series persistence of financial ratio distributions: Empirical evidence with Finnish data. European Institute for Advanced Studies in Management.
Working Paper 89-04.
Whittington, Geoffrey (1980). Some basic properties of accounting ratios. Journal of Business Finance & Accounting 7:2, 219-232.
Wilson, G.P. (1987). The incremental information content of the accrual and funds components of earnings after controlling for earnings. The Accounting Review 62:2, 293-322.
Wilson, G.P. (1986). The relative information content of accruals and cash flows:
Combined evidence at the earnings announcement and annual report date. Supplement to the Journal of Accounting Research 24, 165-200.
Yli-Olli, Paavo & Ilkka Virtanen (1985). Modelling a financial ratio system on the economy-wide level. Acta Wasaensia No. 21. University of Vaasa.
Yli-Olli, Paavo & Ilkka Virtanen (1989). On the long-term stability and cross-country invariance of financial ratio patterns. European Journal of Operational Research 39:1, 40-53.
Yli-Olli, Paavo (1983). Tilinpäätösanalyysissä käytettävien tunnuslukujen luokit-telu ja stabiilisuus. (Summary: The empirical classification of financial ratios and the stability of the classification.) Proceeding of the University of Vaasa. Research Papers No. 95.
Yli-Olli, Paavo & Ilkka Virtanen (1990). Forthcoming. Transformation analysis applied to long-term stability and structural invariance of financial ratio patterns: U.S. vs. Finnish firms. American Journal of Mathematical and Management Sciences 10.
APPENDIX A: The Ratios
ACCRUAL RATIOS Liquidity
- quick ratio
= current assets less inventories / current liabilities - defensive interval measure
= current assets less inventories / daily expenditures to operations - net working capital to total asset
Capital Adequacy
- total liabilities / sales - long-term debt to equity - times interest earned
= earnings before interest and taxes plus depreciation / interest Profitability
- return (after interest and taxes) on equity
= net income / common equity - return on total assets
= net income / common equity - return on total assets