Theoretical Review of the Role of Financial Ratios

ABSTRACT
Purpose – Financial ratios are an instrumental tool in the world of finance and hence
comprehensive knowledge of its various aspects is mandated for its user. This study aims at
providing the aforesaid comprehensive knowledge by highlighting the areas in which ratios
can be used, limitation of ratios and methods to deal with the limitation.
Design/methodology/approach – The study is qualitative in nature and thus utilizes the past
studies and researches to exhibit the various facets of financial ratios. The study incorporates
all the researches that have used ratios as a tool for their study or ratios as the subject matter of
study.
Findings – The study was able to identify and categorise past studies into areas of Financial
evaluation, Insolvency Prediction, Valuation, Inter-linkage studies, Benchmarking & Decision
making, Technical Analysis. Limitations of ratios identified from the literature are Proliferation
of ratios, Lack of Normality and Accounting framework impact.
Originality/value – The study has assimilated unique exhaustive literature on financial ratios
and presented the same in a categorized manner.
Keywords – Financial Ratios, Uses, Limitations, Precautions.
Paper type – Research paper.

AUTHORS:

1. Diwahar S Nadar (Corresponding author)

Assistant Professor, NMIMS (Deemed to be University)
Research Scholar, Symbiosis International (Deemed University)
Email Id: Diwahar.nadar@nmims.edu; sdiwahar@gmail.com

2. Dr. Bharti Wadhwa

Associate Professor, Symbiosis International (Deemed University)
Email-id- bahuja14@gmail.com

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INTRODUCTION

Fundamental analysis is a conceptual derivation of the theory of survival of fittest.

Fundamental Analyst observes and analyzes the various facets of a company to determine
whether the company is fundamentally strong enough to survive and grow in the business
economy (Spooner, 1984). In order for any entity to act in a decisive manner, it is essential to
perform an analysis that covers the company in a comprehensive manner. Only a rigorous and
thorough fundamental analysis can provide the plethora of information that would be required.
A major component of fundamental analysis is financial statement analysis which consists of
intricate activities required to derive the aforesaid knowledge (Bernstein, 1975).
The Ratios & Proportion as a mathematical concept was covered in an abstract manner by
Euclid in his Book V of Elements. (Horrigan, 1968). A financial ratio is a ratio where both the
numerator and the denominator are taken from the financial statements of an organization
(Horrigan, 1968). Financial ratios are a representation of financial elements in proportion to
each other. Through its multi-dimensional information absorption features, ratios have become
the prime analytical tool for any fundamental analyst.
It is inconceivable that accounting data can be analyzed without transforming it into ratios, thus
justification of financial ratios would also be an important justification of financial accounting
(Horrigan, 1965).
The current prominence of financial ratios in the effect of the vast amount of information
contained in a set of financial statements and to enable comparability of differently sized
companies. For the stakeholders of a company, financial ratios not only provide information
about the current but also about the future position of the company (Faello, 2015; Gallizo &
Salvador, 2003).
Financial ratios are predominantly prevalent in all facets of financial analysis but their use
required exhaustive understanding of their abilities and limitations. Thus, it is essential to
understand the nature and use of financial ratios in a wholesome manner.

BRIEF HISTORY OF FINANCIAL RATIOS

The advent of loans in the early 1870’s made the commercial banks request the companies to
provide financial details. This became a widespread activity during 1890’s because of which
the availability of financial information increased tremendously. This was the period during
which financial statement analysis gained significance. (Horrigan, 1968). After 1890’s the
practice of classification into current & non-current was initiated which led to the use of current
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ratio. Thus, the current ratio became the first financial ratio to be used. (Beaver, 1966; Horrigan,
1968). For any fundamental analyst, financial ratios provide the required snapshot of an entity’s
financial position (Muresan & Wolitzer, 2004). In 1912, Alexander Wall realising the
requirement for more variant of financial ratios and published a report in 1919 titled “Study of
Credit Barometrics" (Wall, 1919).
Almost in the same time, ratios were used to evaluate managerial efficiency in retail sector.
The use of ratios in the form of profit margins and turnovers was well developed. Du Pont in
1919 began the most comprehensive usage of three ratios for evaluation of operating results
(Horrigan, 1968). Following decades saw remarkable explosion in literature on ratios and the
proliferation of financial ratios. These developments have been considered as the effect of
Wall’s 1919 study.

OBJECTIVE
The Analysis & Interpretation of Financial Ratios provides information which aids in the
decision making by the stakeholders who are interested in the financial position and operating
results of a business. This study tries to present a collective review of the various uses of
financial ratios and the limitations in their use as well. The study would provide a literature-
based demonstration of the various aspects of financial ratios which have been studied for a
long time. The study is qualitative in nature and thus is a resource tool for any entity to gain
substantial information about Financial ratios.

USES OF FINANCIAL RATIOS

Financial Evaluation
Existing literature has proved that financial ratios have played a primal role in understanding
the basic characteristics of a company. Financial ratios have the ability to explain the
fundamentals of any type of organization. The various dimensions of any entity from
profitability to long-term solvency can be comprehended through the use of financial ratios.
Financial ratio is a predominant tool for financial evaluation used by professionals. Based on
the questionnaire sent to 400 CFAs randomly selected from the membership directory of the
Financial Analysts Federation it was concluded that among the items of potential interest to
analysts are financial ratios which relate key parts of the financial statements (Gibson, 1987).
Financial statement ratios are useful in analysing and interpreting the financial statements of
non-profit institutions of higher education (Woelfel, 1987), shipping companies (Wang & Lee,
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2010), Airline industry (Teker, Teker, & Güner, 2016), Hospitality industry (Petroska-
Angelovska & Ackovska, 2016) , Municipal government (Drew Joseph & Dollery Brian,
2016), IT companies (Dulababu, 2017), FMCG companies (Bansal & Singh, 2017), Electricity
industry (Sueyoshi, 2005) and many more. Thus, their pervasive applicability is undisputable.
F-score has been the most recent fundamental technique developed which can be used for
analysis of the fundamentals of a company and also industry analysis. F-score is a testament to
the fact that accounting-based fundamental analysis has the potential to help investors improve
their investment returns. Piotroski F-Score is named after Chicago Accounting Professor,
Joseph Piotroski. The F-score is number score derived by analyzing the change in 9 key
financial aspects of a company. When the change is favorable a point is awarded, thus a
company which scores 9 would be deemed as the best for investment (Piotroski, 2002; Safdar,
2016). F-score has been used by researchers to evaluate companies in different economies
(Hyde, 2013; Hyde, 2015; Young et.al. 2015).

Benchmark & Managerial Control

Benchmarking implies the creation of standards. Benchmarking aids the management is
exercising required controls on the process in order to achieve the organization’s objective.
Financial ratios have been employed in different models for the creation of benchmarks and
thus assist in relevant decision making.
Du Pont model was founded by the Du Pont Company in 1919 but the same came into limelight
in 1950. The model shows a structural break down of Return on Equity (ROE) ratio into 3
component ratios which enables management to exercise control over those component ratios
which would lead to the improvement of ROE (Bhattacharya, 2007). F. Donaldson Brown was
hired by Du Pont Company to analyze the finances of a newly acquired company which was
General Motors. F. Donaldson Brown who was also an electrical engineer and had also worked
for 4 years in the Treasury Department recognized the mathematical relationship that existed
between two financial ratios Net profit margin and Total assets turnover. The product of these
ratios gave the output as Return on Assets. This was the initial Du Pont model. Later on, the
Du Pont model was developed for ROE with 3 component which was even further extended
by studies to 5 components in order have more effective control (Liesz, 2002). Various studies
have used the Du Pont model to analyze companies of different nature. (Little, Little, & Coffee,
2009; Almazari, 2012).
Benchmarks are also created by researchers in the form of a composite index which is made up
of ratios. These indexes work as a benchmark for the company to compare their performance
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with. Financial ratios are the most suitable to become the core component of the fundamental
index because of their ability to depict the various fundamental dimensions of a company
(Arnott, Hsu, & Moore, 2005; Jia & Li, 2015).

Solvency Evaluation Studies

Insolvency of a company is a disruptive force that has a far-reaching impact on any economy.
Thus, various researchers have tried to predict the possibility of such insolvency. Models have
been developed with the use of financial ratios which aid in identifying entities which might
become insolvent. The prediction of an entity’s operating and financial problems is an area
which has been particularly amenable to analysis of financial ratios. (Altman, 2000).
The use of financial ratios for solvency detection started in the early 1940's. The initial attempts
to use ratios for solvency evaluation was assimilated in Merwin's study who had identified
three ratios as indicators (Horrigan, 1968).
The models Beaver, 1966; Horrigan, 1966; Daniel, 1969; Altman, 1968; Deakin, 1972 have
researched the use of financial ratio information. These models have provided guidance to
management and investors about the future viability of the company. These authors defined the
usefulness of financial ratios in terms of their predictive ability. Predictive ability was
measured by determining the statistical predictive relationship between financial ratios and
some specified real-world phenomenon, e.g., Altman: bankruptcy, Beaver, Daniel, and Deakin:
business failure and Horrigan: long-term credit standing. Using the models as base there were
various other models that were formulated in a specific manner for a particular economy or a
particular nature of company (Beaver, 1968; Deakin, 1972; Blum, 1974; Kennedy, 1975;
Altman & Eisenbeis, 1978; Ohlson, 1980; Carson, 1994; Shirata, 1998; Edmister O., 2012;
Zeytinoglu & Akarim, 2013; Almansour, 2015).
Although various researchers have been conducted in the field of insolvency prediction the
Altman Z-score introduced by Altman has been the primal model applied all over the world.
Thus, the Z-Score Model has been in existence for more than 45 years but has undergone
various modifications and refinement by researchers. The model which was conceived in 1968
has been improved with the advent of the new multivariate statistical model (Altman, 1968;
Altman & Saunders, 1991; Altman & Hotchkiss, 2005; Altman & Rijken, 2011). A review of
all such researchers in the area of insolvency prediction was provided by Altman. The aforesaid
paper enlists all the models of insolvency prediction that have been formulating and the specific
areas in which they could be used (Altman et. al., 2014).

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Using the above-mentioned researches as base various highly stochastic measures were
developed such as fuzzy logic (Korol & Korodi, 2011), Hazardous modelling (Bharath &
Shumway, 2008; Shumway, 2001), Survival analysis (Lee, 2014; Pereira, 2014; Gepp &
Kumar, 2015). All these models as well have ratios as their basic input along with many others
vivid factors.

Technical Analysis
The field of financial analysis consists of fundamental analysis and Technical Analysis.
Technical analysis is the analysis of market action as opposed to studying the goods in which
the market deals. Financial ratios are a component of fundamental analysis yet have been
instrumental in technical analysis. Fundamental analysis aid technical analyst in predicting
stock prices. Various researchers have tried to identify the relationship between market created
share price and fundamentals depicting financial ratios. Post-establishment of the relationship,
these models have attempted to predict the share price as well.
Researchers have been successful in statistically establishing the stock price predictive ability
of financial ratios in various economies and sectors. (Brioschi, Ghezzi, & Mosconi, 1990;
Chan, Hamao, & Lakonishok, 1993; Abarbanell & Bushee, 1997; Mukherji, Dhatt, & Kim,
1997; Abad, Thore, & Laffarga, 2004; Lewellen, 2004; Babu, Geethanjali, & Satyanarayana,
2012; Iqbal, Khattak, & Khattak, 2013; Rahman & Hassan, 2013). F-score has also been used
for prediction of the share price. (Mohr, 2012)

Inter-linkage Studies
Financial ratios enable management to analyze the inter-linkages that exist between different
dimensions of business. Researchers have attempted to identify the relationship that exists
between a company’s dimensions like capital structure, working capital, leverage, and
profitability. Ratios act as a representative for the aforesaid dimensions.
Capital structure decision and the factors determining it have been identified by various
researchers by using financial ratios as the tool for research (Michaelas, Chittenden, &
Poutziouris, 1999; Z. Murray & K. Vidhan, 2009; Edwin O., Robert, & Josef, 2012; G. Philip,
Eli, & L. David, 2012; Sheridan & Wessels, 2012; Michael, Gregg, & Han, 2012).
Studies have also been performed with the aim to establish linkages between the capital
structure and profitability. These researches have proved the existence on an impact of the
capital structure on profitability (Hung, Albert, & Eddie, 2002; Marcos & Lara, 2003; Abor,
2005; Gill, Biger, & Mathur, 2011; T. & J Aloy, 2012).
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Researches have studied the working capital dynamics as well with the aid of ratios. The
multiple ratios which deal with working capital aspects of a company enable researchers to
analyze and extrapolate information in a better manner. These researches have analyzed the
trend of working management and its impact in profitability (Marc, 2003; Raheman & Nasr,
2007; Gill, Biger, & Mathur, 2010; Sharma, 2016; Nadar, Navalkha, Nair, & Damani, 2017).
Not only interrelations within a Company but also the interrelations among companies can be
analyzed with the help of financial ratios. Researchers have enabled categorization of
companies into industries on the basis of the common features among them. The trend of
various financial ratios can also be used as a base for the formation of the industry. This aids
the investors in easily predicting the effect of any event on the Industry in a comprehensive
manner (Gupta & Huefner, 1972).

Valuation
Valuation researches using the financial statement-based information to estimate the equity or
company value has emerged since 1990’s. Researches have attempted to evaluate the
fundamental structure of a company by identification of relevant ratios. (Lee, 1999; Nissim &
Penman, 2001).
Financial ratios along with non-financial factors like the market price can enable stakeholders
to estimate the value of an entity. Multiples are ratios which use share market price as one of
the components. Various Multiples such as Price to earnings ratio, price to Book value ratios
among others have been a crucial component in various researches. These multiples have been
instrumental in evaluating a company and affixing a value to it. Residual Income valuation
method uses financial elements in their absolute form and not in ratios. Opposite to it, Relative
valuation method uses multiples. Researches have also proved how fundamental value backed
relative valuation can be superior to future estimate based discounted cash flow techniques.
(Barth, Beaver, & Landsman, 1998; Latta, 1999; Campbell & Shiller, 2001; Danielson &
Dowdell, 2001; Carlson, Pelz, & Wohar, 2002; David E. & Mark E., 2005; Coakley & Fuertes,
2006; Reschreiter, 2009).
The concept of Enterprise which uses market price as its constituent has also given rise to the
new generation to multiples such as Enterprise value to EBIT, Enterprise value to sales,
Enterprise value to Assets amongst others. These multiples have given a new paradigm for
evaluation of companies. (Jia & Li, 2015; Fernandez, 2017).
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Earnings Management
Another recent area of use of financial ratios has been to aid in detection of Earnings
Management. Tools are required to detect whether the financials of a company are created with
the intention on representing an intended picture.
Complex tools with the aid of financial ratios such a Beneish M score and the Montier C score
to enable stakeholders in evaluating the probability of the earnings management of the
company. Beneish (1999) developed a model to identify earnings manipulators by combination
of financial statement variables. Various studies have proved the ability of Beneish M score to
detect earnings manipulators in various economies (Herawati, 2015; Kamal et. al., 2016; Ofori,
2016; Rahimian, & Haji, 2019). C score designed by Montier (2008) has become a fundamental
step in evaluation of earnings management. The C score also takes into account unique
financial statement based variables to fulfil the objective.

LIMITATIONS OF FINANCIAL RATIOS

Proliferation of Ratios
Since ratios reflect the proportional relation between different financial elements, there are has
been a proliferation of ratios. Initially, in 1925, a researcher has published almost 40 ratios.
The growth of a number of financial ratios to show linkages among various financial elements
has proven troublesome for various stakeholders (Bhattacharya, 2007). It would be infantile to
assume that all the ratios would prove unique information to the user. Analysing all the
financial ratios would be resource consuming. Undertaking Analysis on the assumption that all
the ratios are relevant for all the sectors might lead to the inappropriate outcome. For different
sectors information provided by ratios would differ. Various model including Altman z-score
and F-score are generic in nature and thus fail to take into account the redundancy in ratios.
Thus, there exists a need to reduce the number to ratios to few ratios which would provide most
of the information and would be sector specific (Gupta & Huefner, 1972; Chen & Shimerda,
1981; Shivaswamy, Hoban, & Matsumoto, 1993; Karatas et.al., 2005; Wang & Lee, 2008; De,
Bandyopadhyay, & Chakraborty, 2011; Erdogan, 2014).

Ratios Patterns
Various researches have studied the distributional properties of financial ratios. They have
proved that financial ratios do not conform to the normal distribution. This phenomenon is
caused due to the existence of skewness created due to the existence of bounded and unbounded
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ratios. Bounded ratios are ratios where the value of the numerator financial element cannot
exceed the denominator e.g. Current Assets to Total Assets, Net profit to Sales, Equity to total
funds amongst others. Thus, implying that parametric tests cannot be used on financial ratios.
(Van der Heijden, 2011).
Despite this inherent limitation of ratios, many researches have used parametric tests on
financial ratios which is statistically invalid. Use of multiple regression and multiple
discriminant analysis has been pervasive in order to establish relationships among factors. Such
tests are parametric in nature i.e. normal distribution is essential. Altman Z score was also
formulated with the aid of Multiple Discriminatory Analysis which is a parametric test. The z
score was criticised for that by other researches because of this reason. (Joy & Tollefson, 1975)
Thus, financial ratios have restricted the use of statistical techniques due to their distributional
properties (Deakin, 1976; Martikainen et. al., 1995; Trigueiros, 1995; Chong, Yap, &
Mohamed, 2013; Linares, Coenders, & Vives, 2018).

Ratios Comparability
It’s a common misconception that ratios can be compared across without any limitation. Ratios
are financial extracts and thus are susceptible to the limitations possessed by financials
themselves. The Accounting framework prevalent in any economy influences the financials to
a great extent. Changes in the accounting framework create a great divide in comparability of
financials. Thus, financials before and after a change of accounting framework cannot be
compared. Similarly, economies which do not share the same accounting framework cannot be
compared. Example, US which follows US GAAP and India which follows Indian GAAP are
different in nature and thus the financial created in across with those respective frameworks
cannot be compared (Schipper, 2005; Hung & Subramanyam, 2007; Jeanjean & Stolowy,
2008).
Researches have proved how the impact of such change exists. Studies have shown how for
the same accounting period when the accounting framework changes the financial ratios are
affected to a great extent (Cinca, Molinero, & Larraz, 2005; Liu et. al., 2013; Faello, 2015).
Even within the same accounting framework when different methods are allowed, the
comparability of those financials become weak. When companies use different accounting
policies like Straight line method or Written down value method for depreciation; FIFO or
Weighted average for Inventory valuation, the comparability reduces and accordingly ratios
also become effected. These inherent limitations in the accounting framework is by default
passed down to financial ratios.
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DEALING WITH LIMITATION
Sector-specific ratios
The problem of Innumerable ratios can be dealt with by empirically identifying representative
ratios with the help of statistical techniques. Past studies have employed factor analysis or
cluster analysis with the aim of grouping the ratios and removing redundancy among them.
Thus, with the help of the techniques the ratios which are less in number but provide the same
facets of information emerge. For different sectors in different economies, the representative
ratios would differ. The ratios which capture the most information of that sector would become
the representative ratio of that sector. Thus, statistically identified representative ratios can help
to deal with the limitation of Proliferation of ratios.
The predictive and evaluation abilities of ratios get refined when empirically identified
representative ratios are used (Gupta & Huefner, 1972; Chen & Shimerda, 1981; Shivaswamy,
Hoban, & Matsumoto, 1993; Karatas et.al., 2005; Wang & Lee, 2008; De, Bandyopadhyay, &
Chakraborty, 2011; Erdogan, 2014).

Transformation of values
The lack of normal distribution among ratios can be correct with the use of value
transformations. Researches have attempted to bring in the feature of normality through the
process of log transformations and root transformations. Both the type of transformations may
not be able to completely induce normality but have been successful in bringing the normality
up to a statistically significant level. Thus, along with outlier removal and transformation
normality may be achieved in ratios enabling the researcher to use parametric test (Deakin,
1976; Martikainen et. al., 1995; Trigueiros, 1995; Chong, Yap, & Mohamed, 2013; Linares,
Coenders, & Vives, 2018).

CONCLUSION
This study attempted at undertaking a collective review of the existing literature on financial
ratios to present comprehensive and concise information. The importance of financial ratios
has become evident through the various researches conducted over a period of time. From
initially being used in the form of current ratio, ratios have dwelled into the areas of valuation,
insolvency prediction, and many others the same of which have been categorized and presented
in this study. Financial ratios also possess certain inherent limitation which any user should be
aware of for optimum utilization of ratios as a tool. Using ratios without understanding its
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inherent limitations would be considered as an erroneous act which may provide the users with
wrong conclusions. Researchers that have attempted to overcome the aforesaid limitations have
also been categorized and depicted in the study.
This study would enable the reader to understand the limitations and overcome them in an
effective manner. Thus, the study would aid the reader with knowledge of all the varied uses
of financial ratios along with the limitations and certain precautionary measures to be adopted.

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