An Empirical Analysis of Useful Financial Ratios

Abstract

* Financial ratios have played an important part in evaluating the performance and financial condition of an entity. Over the years, empirical studies have repeatedly demonstrated the usefulness of financial ratios. For example, financially-distressed firms can be separated from the non-failed firms in the year before the declaration of bankruptcy at an accuracy rate of better than 90% by examining financial ratios [1]. In determining bond ratings, when financial ratios were the only variables used, the resulting ratings were virtually identical with institutional ratings [21]. There is one recurring question with the use of financial ratios: which ratios, among the hundreds that can be computed easily from the available financial data, should be analyzed to obtain the information for the task at hand? We hope here to help resolve the problem of ratio selection by examining ratios found useful in recent empirical studies, reconciling the differences in the ones found useful in these studies, and categorizing them by seven factors suggested in the literature. There are many useful ratios reported in the literature. Discrimination is needed to identify a limited set of financial ratios. Naturally, different researchers often include different ratios. Consequently, results on the usefulness of specific ratios vary. Exhibit 1 summarizes a number of such studies and the ratios they employed. The 26 studies analyze more than 100 financial items, of which 65 are accounting ratios. Forty-one of these are considered useful and/or are used in the final analysis by one or more of the researchers. Given such a heterogeneous set of useful financial ratios, the decision-maker has to be at a loss in selecting which ratios to use for the task at hand. Conceivably, 41 ratios cannot all be significant or equally important in a multi-ratio model. The decision-maker may hesitate to omit a ratio if it has been found useful in one or more of the empirical studies. Yet, it is impossible to include most of the useful ratios found in the literature. Which ratios, then, should be deleted, and which should be included? Should the results from only one study, the results from a combination of studies, or the results from all the studies be used? If only one study is to be used, which one should it be?