Modelling a Financial Ratio System on the Economy-Wide Level

Paavo Yli-Olli and Ilkka Virtanen

Abstract

The purpose of this study is to develop, on the economy-wide level, an empirically-based classification pattern for commonly used financial ratios and to measure the long-term stability of the ratios. The data used for this study consists of December 31 fiscal year US industrial firms for the period 1947-75. The selected financial ratios are according to a priori classification the measures of short-term solvency, long-term solvency, profitability, and efficiency. Classification patterns of the financial ratios are developed via factor analysis and the stability analysis is carried out via transformation analysis.

The empirical results show that empirically-based classifications are not fully equivalent to the a priori classification. The following factors are found: solvency, profitability, efficiency, and dynamic liquidity. The empirical results are based both on the value- and equal-weighted indices of the ratios. Classification patterns are developed using variables (indices) both in the level and in the first-difference form. The use of the first differences of ratios becomes necessary because of the clear positive or negative trend in the time series. The use of first differences of ratios makes it also possible to overcome the open and quite serious problem concerning the role of constant term in financial ratio analysis. Further, empirical results show that different aggregation methods lead to different results. The theoretically better value- weighted indices (in the first-difference form) give more accurate and intepretative empirical results. Factor patterns based on value-weighted variables in the first difference form display also very clear time series stability. This result confirms the great importance of aggregation method in ratio analysis. Finally, some demonstrations how to use financial ratios in macro-economic analysis are presented.

Key words: Financial ratio analysis, classification of financial ratios, stability of financial ratios, aggregation of financial ratios, factor analysis, transformation analysis

(Acta Wasaensia, No. 21 (1985), 74 p.)