Financial Statement Analysis: A Data Envelopment Analysis Approach

Author(s): E. H. Feroz, S. Kim and R. L. Raab

Source: The Journal of the Operational Research Society , Jan., 2003, Vol. 54, No. 1
(Jan., 2003), pp. 48-58
Published by: Palgrave Macmillan Journals on behalf of the Operational Research
Society

Stable URL: https://www.jstor.org/stable/822748

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 *^
Journal of the Operational Research Society (2003) 54, 48-58 ?2003 Operational Research Society Ltd. All rights reserved. 0160-5682/03 $15.00

www.palgrave-journals.com/jors

Financial statement analysis: A data envelopment

analysis approach
EH Ferozl*, S Kim2 and RL Raab1

1University of Minnesota, Duluth, MN, USA; and 2Rutgers University, Camden, NJ, USA, and
Singapore Management University, Singapore

Ratio analysis is a commonly used analytical tool for verifying the performance of a firm. While ratios are easy to
compute, which in part explains their wide appeal, their interpretation is problematic, especially when two or more ratios
provide conflicting signals. Indeed, ratio analysis is often criticized on the grounds of subjectivity, that is the analyst must
pick and choose ratios in order to assess the overall performance of a firm.
In this paper we demonstrate that Data Envelopment Analysis (DEA) can augment the traditional ratio analysis. DEA
can provide a consistent and reliable measure of managerial or operational efficiency of a firm. We test the null hypothesis
that there is no relationship between DEA and traditional accounting ratios as measures of performance of a firm. Our
results reject the null hypothesis indicating that DEA can provide information to analysts that is additional to that
provided by traditional ratio analysis. We also apply DEA to the oil and gas industry to demonstrate how financial
analysts can employ DEA as a complement to ratio analysis.
Journal of the Operational Research Society (2003) 54, 48-58. doi:10.1057/palgrave.jors.2601475

Keywords: accounting; data envelopment analysis; finance

Introduction In the Coasian tradition of the theory of the firm and

related transaction cost analysis,' surviving firms indicate
Financial analysts commonly use ratio analysis to measure
that there may be some firm-specific production or manage-
the performance of firms. Finance and accounting texts
rial efficiencies that are unlikely to be replicated by other
devote a section to ratio analysis as a summary of accumu-
firms in the same industry and the market, or those firms
lated knowledge necessary for the preparation of financial
would not have survived in the first place. Earlier studies
statements that are designed to report the performance of the
have demonstrated the general usefulness of Data Envelop-
entities to the stakeholders. During the late 1970s and early
ment Analysis (DEA) in various decision contexts2 such as
1980s, the methodology of ratio analysis was considered
evaluating the income efficiency implications of the OSHA
suspect, especially by the advocates of the strong form of
health and safety regulations.3 In this paper, we argue that
the efficient market hypothesis. However, in the wake of the
DEA can complement traditional ratio analysis especially if
stock market crash of 1987, the level of faith in the
the goal is to provide information regarding the operating
informational efficiency of the market waned, and ratio
and technical efficiency of the firm. Indeed, we demonstrate
analysis again seemed to gain ground in academic literature.
that there is a correspondence between the measurement of
efficiency using ratios and the direction of the relative
efficiency trends of firms as captured by DEA. Our null
*Correspondence: EH Feroz, 137 School of Business and Economics, hypothesis is that there is no relationship between the DEA
University of Minnesota, Duluth, 412 Library Drive, Duluth,efficiency MN scores and those of financial ratios. Our empirical
55812-2496, USA.
results demonstrate that there is a relationship between the
E-mail: eferoz@d.umn.edu
deviations from the optimum DEA efficiency scores and the
Please do not quote without the permission of the authors. The algo-
rithms used in this paper have provided a basis for Invention Disclosure
deviations from the optimum financial ratios.
with the University of Minnesota Patent Office.
The rest of the paper is structured as follows. The next
Earlier versions of this paper were presented before the annual meeting
of the Operational Research Society OR43; Accounting-Finance workshop section articulates the relationship between DEA and tradi-
of the University of Wisconsin-Milwaukee; Annual Meetings of the Amer-tional ratio analysis. The following sections revisit the ratio
ican Accounting Association, Dallas, Texas; Annual Meetings of the
Financial Management Association, New York; and the Western Economic
methodology in order to demonstrate the usefulness of DEA
Association Meetings, Vancouver, B.C. as a composite tool of financial statement analysis. A further

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 EH Feroz et al-Financial statement analysis 49

section illustrates the application of DEA to the oil and gas incorporated into an operational definition of efficiency;
industry. The last section offers some conclusions. revenues are maximized subject to the constraints from
employing long-term (assets and equity) and short-term
(costs) resources.
Financial statement analysis: A DEA approach
Financial statement analysis has traditionally been per-
Review of ratio methodology
formed using a set of ratios to highlight the relative
performance of a firm as compared to its industry. The Best cases favoring the validity of ratios can be found in
number of ratios that can be computed on the basis of Beaver4 and Davis and Peles.5 Davis and Peles suggest that
financial data is constrained only by the imagination of the financial ratios do have equilibrium values; that is, they
analyst. However, only a subset of the potentially infinite adjust to target values that may be managerially predeter-
number of ratios can be meaningfully interpreted. Currently, mined or may be simply an industry average. Davis and
the Generally Accepted Accounting Principles (GAAP) in Peles distinguish ratios in terms of their differential rates of
the USA mandate that only earnings per share (EPS) related adjustment to their equilibrium values. They predict that
ratios be reported in the financial statements. Financial some of the ratios such as liquidity ratios are more likely to
analysts, however, consider many other ratios. Two pro- adjust faster than others.
blems with the traditional financial statements analysis are The rows of Table 1 show the descriptive statistics for the
the one ratio at a time approach and the subjective choice of three groups of the most commonly used ratios. The first
specific ratios to assess the overall health of a firm. So, we group represents five liquidity ratios for the 29 COMPU-
propose a more integrative model incorporating much of the STAT firms over a 20-year period (1973-1992) for the oil
information contained in financial ratios. and gas industry. The oil and gas industry is used as an
DEA can be applied to revenue-producing organizations example in this portion of the paper and comparable tables
by converting financial performance indicators to their for the pharmaceuticals and primary metals are not included
technical efficiency equivalents. One such approach is to here (but are available from the authors upon request). The
disaggregate Return on Equity (ROE) using the DuPont three unrelated industries were selected to test the null
model. ROE, measuring the relationship of net income to hypothesis since ratio analysis is quite subjective and indus-
common equity, can be decomposed as follows: try specific. The second and third group of ratios comprise
NI S A five commonly used performance measures and six com-
ROE= - x x (1) monly used solvency ratios for these COMPUSTAT firms
S A B
over the same period of time. Table 1 contains the descriptive
where profit margin = net income
statistics of the(NI)/Sales (S);
financial ratios for the asset
oil and gas industry.
utilization = sales (S)/Total Assets (A);
The mean andequity
median ratios multiplier = conven-
appear to have quite
total assets (A)/common equity tional (E). This
values and decomposition
generally are representative of COMPU-
facilitates the examination of ROE in
STAT terms
firms of a Very
and industries. measure of
small differences between
profitability (profit margin),the mean andof
level median values of the
assets ratios are evident.
required toMore-
generate sales (asset utilization), and
over, these ratios the financing
are computed for 29 firms overof20 years
those assets (equity multiplier).comprising
As such, betweenROE565 and encompasses
580 observations per ratio.
measures of sales, net income, Tabletotal assets,
2 provides the serial and common
correlation coefficients of the
equity. first differences and lagged first differences of the dated
The components given above (sales, net income, total financial ratios, which have been aggregated on a DMU
assets, and common equity) define important dimensions of (decision making unit) by DMU basis for the oil and gas
the technical efficiency of a revenue-producing organization. industry. For the 20 years of data, 19 first differences were
That is, sales, total assets, and common equity can be computed and 18 pairs of values were used to compute these
minimized as inputs, and net income can be maximized as serial correlation coefficients. This procedure resulted in a
an output. This view identifies a technically efficient firm as sample of 29 correlation coefficients per ratio. If mean
using a minimum of resources yet producing a maximum of reversion occurs in period one, then the coefficient should
net income. Because DEA does not work with negative be -0.5. The mean reversion process occurs when a
numbers, the approach of explicitly modelling net income financial ratio reverts back to an original value (i.e., an
(losses) may not be appropriate. The linear programming equilibrium value) as quickly as one year. This is the fastest
problem of accommodating negative net incomes (net speed of adjustment and the serial correlation will approach
losses) can be addressed by defining the inputs as total a value of -0.5.
assets, common equity, and costs, and defining the output as On the other hand, in a random walk, the mean reversion
total revenues. This latter approach is used in this paper. process does not occur, and the correlation coefficient will
In this way, financial ratios, commonly used to assess approach zero. Consistent with the Davis and Peles results
the financial performances of a firm, are systematically the serial correlation coefficients for liquidity ratios and

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50 Journal of the Operational Research Society Vol. 54, No. 1

Table 1 Descriptive statistics for raw ratios (1973-92) for oil and gas industry

Ratio Mean Median a Max Min

(a) Liquidity ratios

CURAT* 1.414 1.340 0.515 7.782 0.000
QRAT 0.933 0.880 0.459 6.940 0.000
CSHRAT 0.214 0.190 0.150 0.910 0.001
INVRAT 0.292 0.280 0.134 0.690 0.000
CADCMA -0.278 -0.300 0.088 0.000 -0.370

(b) Performance ratios

PEPS 2.070 1.990 3.530 19.000 -51.000
EPSPI 2.914 2.060 3.826 37.600 -51.000
EPSPX 2.050 2.010 3.244 16.500 -51.000
ROS 0.173 0.150 0.132 0.800 0.000
ROA 0.164 0.160 0.072 0.510 0.001

(c) Solvency ratios

EQDRAT 0.948 0.875 0.485 0.339 0.000
GMRAT 0.263 0.240 0.178 0.950 0.160
EQFAR 0.691 0.680 0.356 2.410 -4.500
SFARAT 2.361 1.865 1.742 14.100 0.180
SEQRAT 3.394 2.720 2.505 20.500 0.260
RTARAT 0.295 0.320 0.161 0.670 -0.740

*CURAT = Current Assets/Current Liabilities

CSHRAT = (Cash/Current Assets), INVRAT =
Current Liabilities) * log (Cash/Current Ass
Extraordinary & Discontinued Items, EPSPX = P
ROS = Operating Income/Sales, ROA = Operatin
Common Stock)/(Current Liab + Long-term
(Preferred Stocks + Common Stocks)/Fixed
Sales/(Preferred Stocks + Common Stock), RTA

performance measures where Yand X represent

are generally the
higher effi
than
vency ratios. Similar values between mean an and input vectors.
coefficients also confirmSince the the optimum value
symmetry for di
of the a
of the coefficients. Thus we conclude that the three indus- one (1), the formula for determi
tries that we analysed have mean reversion processes similar the optimum for the DEA effici
to the more general group of firms comprising the Davis and
(3)
Dit = 1 - DEAit,
Peles sample.
where D stands for deviation for ith firm (DMU) at the
tth year.
Relationship between accounting ratios and Similarly for the financial ratios listed in Table 2, we first
DEA efficiency scores determine the optimum values (operationally interpreted as
In this study we stipulate that if DEA is a complement to the maximum values) for each of these ratios for a particular
traditional accounting ratios, then there will be a relationship year and then determine the deviation from optimum values
between the ratios and DEA efficiency scores. However, if for individual ratios. In determining the optimum value for a
DEA efficiency scores have incremental information content ratio for a particular year, we define the industry as the
over and above traditional ratios, we will expect that the population in order to be consistent with our DEA notion
relationship between ratios and DEA scores will not be a that the group of firms (DMUs) constitute the universe. In
perfect one. other words, the deviation for individual ratios is computed
In order to test our null hypothesis that there is no as follows:

relationship between accounting ratios and DEA, we first RDit = Rmax - Rit (4)
compute the deviations from the optimum both for the
individual ratios and the DEA efficiency scores. The DEA where RDit is the deviation for a particular ratio for the ith
efficiency score is defined as: firm (DMU) in year t, Ri is taken from the individual ratios
in Table 2 and Rmax is the maximum (optimum) value of the
DEA eTYp
= + eTXp
P+ P (2) ratio, which is selected from all of the firms (DMUs) in the
eTy + eTXp + eTS+industry.
+ eTS-

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 EH Feroz et at-Financial statement analysis 51

Table 2 Descriptive statistics for serial correlation coefficients for oil and gas industrya

Ratio Mean Median a Max Min

(a) Liquidity ratios

CURAT* -0.160 -0.154 0.182 0.173 -0.591
QRAT -0.189 -0.200 0.181 0.181 -0.591
CSHRAT -0.217 -0.232 0.221 0.326 -0.616
INVRAT -0.107 -0.089 0.210 0.251 -0.649
CADCMA -0.265 -0.266 0.171 0.071 -0.548
(b) Performance ratios
PEPS -0.284 -0.270 0.204 0.079 -0.622
EPSPI -0.242 -0.269 0.201 0.150 -0.640
EPSPX -0.180 -0.202 0.195 0.183 -0.487
ROS -0.064 -0.056 0.205 0.363 -0.501
ROA -0.190 -0.213 0.183 0.254 -0.213
(c) Solvency ratios
EQDRAT -0.111 -0.104 0.223 0.411 -0.591
GMRAT -0.016 -0.016 0.189 0.391 -0.490
EQFAR -0.073 -0.041 0.203 0.385 -0.546
SFARAT -0.013 -0.004 0.23 0.315 -0.427
SEQRAT -0.176 -0.173 0.238 0.354 -0.556
RTARAT -0.075 -0.058 0.213 0.403 -0.485

aSerial correlation coefficients are calculated for each r

*CURAT = Current Assets/Current Liabilities, QRAT
CSHRAT =(Cash/Current Assets), INVRAT = Invent
Current Liabilities) * log (Cash/Current Assets), PEP
Extraordinary & Discontinued Items, EPSPX = Peps excl
ROS = OperatingIncome/Sales, ROA = OperatingIncom
Common Stock)/(Current Liab + Long-term Debt),
(Preferred Stocks + Common Stocks)/Fixed Assets, S
Sales/(Preferred Stocks + Common Stock), RTARAT =

Once we have computed the where deviations of (P-value)

the correlation coefficients the are individua
significant
ratios from the optimum, atwe transformed them
10% or less for 14 to 19 of the 20 years. to a 0-
If the DMUs
scale by using the following formula: of the three industries are combined and a
considerably larger "n" results for each of the 20 years, a
somewhat different pattern of significant correlation coeffi-
RD. t R(5)
Rmax - Rmin cients results. If longer term ratios appeared more important
for the total of the industries (Table 4 summarised in Table
Note that this scaling was necessary in order to make the 5, column 4: DSFARAT and DSEQRAT), then shorter term
deviations of individual ratios comparable to the deviations ratios appeared more important for the three industries
of the DEA scores, which range from 0-1. It is also pooled (Table 5, column 5: DCURAT, DQRAT, and
noteworthy that the deviations (Di) computed here are theo- DCSHRA). In short, no evident pattern of ratios are
retically more justifiable and not the same as the speed of highly correlated between particular industries or the totals
adjustment computed in Davis and Peles. Unlike the present of the three industries, or even when the three industries are
study, the Davis and Peles managerially determined targets pooled. This result is expected since ratios often are criti-
are not identifiable benchmarks. Our deviations are closer to cized for their lack of temporal stability, general applicabil-
the industry-determined targets in the sense that we define ity, and industry specificity. A specific ratio, measuring a
industry as the population in order to determine the opti- specific dimension of firm behavior, may be applicable only
mum value for a particular ratio. to a specific industry over a limited period of time.
As Table 3 summarised in column 1 Table 5 indicates, Table 5 summarizes the number of significant correlation
there is a correlation between the deviations of the ratios and coefficients for the three industries. Not unexpectedly, the
the DEA efficiency deviations. Particularly noteworthy are significant ratios, with respect to statistical significance and
relationships between DEA deviations and DSFARAT, income efficiency, for the oil and gas industries may or may
DROS, DGMRAT, and DSEQRAT (scaled versions of not be significant in the pharmaceuticals or primary metals
SFARAT, ROS, GMRAT, and SEQRAT, respectively)industries. For example, DROS (scaled version of ROS in

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52 Journal of the Operational Research Society Vol. 54, No. 1

Tables 1 and 2) had 14 out of 20 significant correlation of significant correlation coefficients were summed across
coefficients for oil and gas, but only 1 out of 20 for industries, DSFARAT seemed to be fairly significant for 43
pharmnaceuticals and only 6 out of 20 for primary metals. of the 60 possible years, followed by DSEQRA with
It appears that certain ratios are appropriate for analysing 35 years; DROA and DCSHRA are the third (31 years)
certain industries and not others. However, when the number and fourth (29 years), respectively.

Table 3 Correlation coefficient between the deviations of ratios and DEA deviation scores for the oil and gas industry'

1973 1974 1975 1976 1977 1978 1979 1980 1981

DCURATb 0.367 -0.019 0.124 0.3 17 0.168 0.176 0.107 -0.132 -0.036
P-value 0.07 0.92 0.54 0.11 0.41 0.38 0.61 0.51 0.86
n 25 25 28 28 28 28 25 26 26

DQRAT 0.332 -0.025 0.303 0.25 1 0.06 0.267 0.124 -0.488 -0.144
P-value 0.09 0.89 0.13 0.21 0.77 0.18 0.58 0.01 0.49
n 25 25 28 28 28 28 24 25 25

DCSHRA 0.185 0.089 0.247 0.238 -0.342 0.211 0.072 -0.019 0.196
P-value 0.37 0.66 0.22 0.24 0.06 0.31 0.73 0.92 0.34
n 25 25 25 28 28 25 24 25 25

DINVRAT 0.05 1 0.327 -0.005 0.045 0.004 -0.373 0.023 0.272 -0.024
P-value 0.81 0.11 0.82 0.81 0.99 0.08 0.74 0.17 0.91
n 24 24 25 25 25 25 24 28 28

DEQRAT 0.137 0.196 0.228 0.123 0.201 0.015 -0.166 0.15 0.327
P-value 0.51 0.34 0.58 0.55 0.32 0.94 0.43 0.47 0.09
n 24 25 28 28 28 26 24 25 25

DROS -0.07 -0.093 -0.481 -0.474 -0.549 0.153 -0.006 -0.709 -0.823
P-value 0.74 0.66 0.01 0.01 0 0.45 0.97 0 0
n 25 25 28 28 28 28 25 25 24

DROA 0.398 0.270 0.295 0.28 0.3 16 0.293 -0.001 0.306 0.042
P-value 0.06 0.19 0.14 0.150 0.11 0.14 0.99 0.13 0.84
n 25 28 28 28 28 26 24 25 25

DGMRAT -0.056 -0.139 -0.595 -0.567 -0.607 0.120 0.119 -0.484 -0.51
P-value 0.79 0.51 0 0 0 0.56 0.57 0.01 0
n 25 25 26 26 26 26 24 .26 26

0.27 0.41 0.258 0.403 0.338 0.405

DEQFAR 0.557 0.447 0.117

P-value 0.79 0.02 0.57 0.18 0.03 0.21 0.06 0.09 0.04
n 25 25 28 28 28 26 24 25 25

DSFARAT 0.575 0.484 0.449 0.401 0.508 0.31 0.354 0.347 0.418

P-value 0 0.01 0.02 0.04 0 0.12 0.08 0.08 0.03

n 25 25 28 26 28 26 24 26 26

0.308 0.336 0.215 0.254 0.415 0.402

DSEQRA 0.339 0.273 0.293

P-value 0.04 0.18 0.14 0.12 0.9 0.29 0.23 0.03 0.04

n 25 25 28 28 28 28 24 25 25

0.294 -0.061 0.438 0.427

DRTARA 0.347 0.388 0.422 0.253 -0.03 1

0.15 0.77 0.02 0.03

P-value 0.06 0.05 0.03 0.21 0.88

25 24 25 25
n 25 25 25 26 26

'Significant correlation coefficients (P-value 10% or less) are in bold numbers.

bDCURA~T DQRAT, etc., are scaled ratios of CURAT and QRAT, respectively, in Tables 1 and 2. Each variable per year is scaled do,wn to
1-0 scale as follows: (Maximum Ratio - Ratio)/(Maximum Ratio - Minimum Ratio).
(continued)

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 EH Feroz et al-Financial statement analysis 53

Table 3 (continued)

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

-0.077 0.273 0.047 0.031 0.015 0.162 0.219 0.537 0.108 -0.008 -0.094
0.71 0.17 0.82 0.88 0.84 0.38 0.29 0 0.81 0.97 0.66
25 26 25 25 25 25 25 25 25 25 24

-0.358 0.037 -0.329 -0.318 -0351 -0.032 0.174 -0.586 -0.038 -0.136 -141
0.06 0.85 0.11 0.12 0.09 0.88 0.38 0 0.85 0.51 0.51
24 25 24 24 24 24 25 25 25 25 24

-0.541 -0.388 -0.459 -0.541 -0.485 -0.139 0.153 -0.497 -0.119 -0.2 -0.262
0 0.05 0.02 0 0.01 0.51 0.48 0.01 0.57 0.33 0.21
24 25 24 24 24 24 25 24 24 25 24

0.258 0.352 0.261 0.033 0.269 0.136 0.021 0.134 0.264 0.12 0.211
0.21 0.07 0.19 0.87 0.17 0.52 0.92 0.53 0.19 0.56 0.32
25 28 25 24 24 24 24 24 24 25 24

0.201 0.235 0.083 0.054 0.058 -0.116 -0.268 -0.184 -0.048 0.178 -0.07
0.34 0.25 0.69 0.79 0.79 0.58 0.19 0.38 0.81 0.39 0.74
25 25 24 24 25 25 25 25 25 25 24

-0.849 -0.788 -0.831 -0.881 -0.51 -0.272 0.701 -0.717 -0.137 -0.442 -0.585
0 0 0 0 0.01 0.19 0 0 0.51 0.02 0
25 25 24 23 25 23 26 26 26 26 25

-0.202 -0.007 -0.251 0.208 0.374 -0.363 -0.701 0.200 0.566 0.304 -0.061
0.34 0.97 0.23 0.34 0.08 0.21 0 0.32 0 0.13 0.77
25 25 24 23 22 23 26 26 26 26 25

-0.473 0.437 -0.426 -0.302 0.116 -0.362 -0.782 -0.37 -0.371 -0.502 -0.545
0.01 0.02 0.03 0.14 0.58 0.08 0 0.08 0.08 0 0
25 26 25 25 24 25 26 26 26 26 25

0.511 0.567 0.403 0.333 0.411 0.044 0.229 -0.171 0.073 -0.089 0.009
0.01 0 0.05 0.11 0.04 0.83 0.26 0.41 0.72 0.86 0.97
24 25 24 24 24 24 26 26 28 28 25

0.498 0.465 0.538 0.422 0.539 0.412 0.502 0.492 0.47 0.641 0.533
0.01 0.01 0 0.03 0 0.04 0 0.01 0.01 0 0
25 26 25 25 25 24 26 26 26 26 25

0.464 0.371 0.596 0.56 -0.02 0.474 0.645 0.698 0.416 0.522 0.394
0.02 0.06 0 0 0.91 0.01 0 0 0.03 0 0.05
25 25 24 24 24 24 26 25 26 26 24

-0.092 -0.256 -0.182 0.477 -0.396 -0.299 0.358 -0.225 -0.145 -0.181 -0.094
0.68 0.22 0.41 0.02 0.06 0.17 0.08 0.31 0.51 0.39 0.66
25 24 22 23 23 22 24 22 24 26 23

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54 Journal of the Operational Research Society Vol. 54, No. I

Table 4 Correlation coefficient between the deviations of ratios and DEA deviation scores (Three industries combined)'

1973 1974 1975 1976 1977 1978 1979 1980 1981

DCURATb -0.343 -0.144 -0.226 -0.167 -0.264 -0.303 -0.449 -0.221 -0.200
P-value 0.00 0.20 0.04 0.14 0.01 0.00 0.00 0.05 0.07
n 73 80 80 78 80 77 74 74 79

DQRAT -0.237 -0.047 -0.052 -0.161 -0.208 -0.275 -0.494 -0.158 -0.191
P-value 0.03 0.67 0.64 0.15 -0.05 0.01 0 0.15 0.08
n 76 82 81 78 82 76 75 74 77

DCSHRA -0.121 0.055 -0.313 -0.081 -0.114 0.057 -0.036 -0.158 -0.096
P-value 0.29 0.62 0 0.49 0.31 0.62 0.76 0.15 0.4
n 75 79 76 74 79 75 74 73 77

DINVRAT -0.173 -0.070 -0.074 0.002 -0.020 -0.011 -0.010 0.003 -0.077
P-value 0.14 0.53 0.52 0.98 0.85 0.92 0.92 0.97 0.51
n 73 78 77 77 78 75 71 72 75

DEQRAT -0.118 0.098 -0.173 -0.290 -0.105 -0.050 -0.018 0.029 -0.069
P-value 0.31 0.39 0.12 0.01 0.35 0.66 0.87 0.80 0.58
n 73 78 78 73 79 75 75 73 77

DROS -0.016 -0.069 0.040 -0.204 -0.172 0.128 0.212 0.049 0.061
P-value 0.88 0.55 0.73 0.08 0.13 0.29 0.08 0.88 0.61
n 72 73 72 71 77 70 66 59 69

DROA 0.026 0.110 0.282 -0.152 -0.170 -0.183 0.12 1 0.150 -0.081
P-value 0.82 0.35 0.01 0.20 0.13 0.13 0.33 0.21 0.50
n 72 74 73 70 77 68 68 70 69

DGMRAT 0.137 0.027 0.760 -0.028 -0.171 0.100 0.044 -0.200 0

P-value 0.23 0.8 0.5 0.81 0.12 0.38 0.7 0.08 0.990
n 77 81 78 78 82 76 74 76 79

DEQFAR 0.117 0.139 0.4 13 -0.190 0.217 0.240 0.185 0.112 0.307
P-value 0.32 0.34 0.21 0.09 0.05 0.03 0.11 0.34 0.00
n 73 48 78 78 79 74 74 73 77

DSFARAT -0.129 0.212 0.323 -0.005 0.233 0.417 0.318 0.297 0.363
P-value 0.25 0.05 0.00 0.95 0.03 0.00 0.00 0.01 0.00
n 78 80 77 79 79 73 72 72 77

DSEQRA 0.133 0.08 1 0.379 0.113 0.437 0.387 0.105 0.401 0.143
P-value 0.25 0.45 0.00 0.32 0.00 0.00 0.36 0.00 0.21
n 75 80 79 76 80 74 75 73 78

DRTARA 0.331 0.222 0.126 -0.183 0.320 0.205 0.247 0.120 0.25
P-value 0.01 0.07 0.32 0.12 0.00 0.10 0.04 0.32 0.03
n 59 64 64 64 71 64 67 70 72

'Significant correlation coefficients (P-value 10% or less) are in bold numbers.

bDCURAT, DQRAT, etc., are scaled ratios of CURAT and QRAT, respectively, in Tables 1 and 2. Each variable per year is scaled down to
1-0 scale as follows (Maximum Ratio - Ratio)/(Maximum Ratio - Minimum Ratio).
(continued)

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 EH Feroz et al-Financial statement analysis 55

Table 4 (continued)

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

-0.356 -0.438 0.091 -0.019 0.255 0.107 -0.194 -0.303 -0.294 -0.216 0.005
0.00 0.00 0.45 0.87 0.03 0.38 0.11 0.01 0.01 0.07 0.95
76 74 69 67 66 68 67 89 68 68 64

-0.193 -0.111 -0.013 -0.198 0.090 -0.352 -0.485 -0.312 -0.454 -0.223 -0.382

0.1 0.35 0.91 0.11 0.47 0 0 0 0 0.06 0

73 72 67 66 64 68 67 89 89 85 59

0.042 -0.142 0.037 -0.247 -0.107 -0.137 -0.228 -0.197 -0.213 -0.255 -0.107

0.72 0.23 0.76 0.04 0.39 0.27 0.06 0.1 0.07 0.02 0.39

73 72 66 65 65 66 66 69 69 68 64

-0.192 -0.074 -0.081 -0.100 -0.069 -0.268 -0.176 -0.048 0.107 -0.113 -0.170

0.10 0.53 0.50 0.42 0.58 0.03 0.15 0.69 0.39 0.36 0.18

71 72 68 66 65 65 66 67 66 67 63

-0.127 0.008 0.089 -0.280 -0.047 0.435 0.439 0.003 -0.122 -0.159 0.200

0.28 0.95 0.46 0.03 0.70 0.00 0.00 0.97 0.31 0.19 0.11

73 72 58 66 54 88 66 59 68 68 64

0.010 -0.375 -0.255 -0.269 -0.182 -0.404 -0.480 -0.563 -0.634 -0.498 -0.560

0.93 0.00 0.03 0.01 0.12 0.00 0.00 0.00 0.00 0.00 0.00

66 85 65 66 64 67 87 68 68 67 57

0.160 0.026 0.038 -0.050 0.002 -0.303 -0.159 -0.151 -0.008 -0.095 -0.454

0.29 0.83 0.75 0.68 0.98 0.01 0.15 0.21 0.94 0.43 0.00

45 66 66 66 64 67 67 68 68 67 57

-0.102 -0.182 -0.163 -0.078 0.035 -0.470 -0.120 -0.103 -0.226 -0.078 -0.034

0.39 0.12 0.18 0.52 0.77 0.7 0.33 0.39 0.060 0.52 0.78

71 72 68 68 86 86 68 69 69 88 64

0.444 0.287 0.188 0.233 0.001 -0.081 -0.032 0.034 0.05 1 0.215 0.416

0.00 0.01 0.12 0.06 0.88 0.50 0.79 0.77 0.67 0.07 0.00

73 73 69 65 64 68 66 69 69 68 64

0.099 0.233 0.190 0.103 -0.086 0.070 -0.002 0.115 0.002 0.335 0.1l7 5
0.38 0.04 0.11 0.40 0.48 0.56 0.98 0.34 0.98 0.00 0.16

74 74 69 67 66 68 67 69 6 9 6 8 64

-0.116 0.120 0.309 0.18 0.12 1 0.091 0.134 -0.129 0.045 0.246 -0.076

0.33 0.30 0.01 0.14 0.33 0.45 0.28 0.70 0.70 0.04 0.02

71 73 68 68 65 68 56 69 89 87 64

0.257 0.336 0.304 0.152 0.048 -0.040 0.064 -0.010 -0.010 -0.001 -0.078
0.03 0.00 0.01 0.22 0.70 0.74 0.61 0.93 0.93 0.99 0.55
68 69 65 65 62 67 64 65 65 65 81

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56 Journal of the Operational Research Society Vol. 54, No. 1

Table 5 Number of significant correlations (P-value 10% or less) for three industries separately and combined

Oil and Pharmaceuticals Primary Totala Threea industries

Ratio gas (1) (2) metals (3) (4) pooled (5)
DCURATb 2 9 3 14 13
DQRAT 5 15 3 23 12
DCSHRA 7 18 4 29 6
DINVRAT 2 16 4 22 2
DEQRAT 1 12 3 16 4
DROS 14 1 6 22 11
DROA 4 14 13 31 3
DGMRAT 14 5 5 24 2
DEQFAR 9 11 5 25 9
DSFARAT 19 14 10 43 9
DSEQRA 14 18 3 35 7
DRTARA 8 4 2 14 9

aColumn 4 is the sum of

coefficients were comput
b(Rmax - Rit)/(Rmax -
CURATmin), and so on.

An illustrative
simultaneously producing more or the DEA
same output, with at ap
oil and gas
least oneindustry
strict inequality, then the DMU is deemed techni-
cally efficient. Those DMUs not meeting the above criteria
As have argued, we DEA
are deemed technically inefficient.
the relative technical eff
Chares et al8 developed a sensitivity analysis technique
DMUs) that exhibit the
based on the oo-norm measure of a vector that defines the
outputs. As a linear p
necessary simultaneous perturbations to the component
Farrell's6 notion of tech
vector of a given DMU to cause it to move to a state of
approach to efficiency e
'virtual' efficiency. Virtual efficiency is defined as a point of
frontier composed of t
the efficient frontier where any minuscule detrimental
input as possible (total
perturbation (increase in inputs and/or decreases in outputs)
goods sold in our case)
will cause an efficient DMU to become inefficient or any
(sales) as possible from
minuscule favorable perturbation (decrease in inputs and/or
tion. Those DMUs that
increase in outputs) will cause an inefficient DMU to
efficient, those DM while
become efficient. Once the stability index is known for
inefficient (enveloped b
each DMU, the DMUs can be ranked from most robustly
In this illustration, w
technically efficient to most robustly inefficient. To do so,
Charnes et al.7 The b
the stability indexes for inefficient DMUs are first negated.
model of DEA utilizes t
Then the DMUs can be rank ordered from highest to lowest
and output production
based on their stability index values.
particular DMU's input
As an illustration, descriptive statistics for DEA stability
represents that DMU's
index values are shown for the oil and gas industry in Table 6.
vectors for all DMUs ex
Cross-section DEA stability indexes were calculated for each
empirical production po
year for a maximum of 26 firms. The means of the stability
indexes over the 20 years are shown in the third column.
PE = (T,
Exxon's
XT)=
large positive value indicates a robustly efficient firm
E
i= 1 /,l
(DMU). A large standard deviation indicates large variation
Elpi = 1, iii > o} in predominantly positive stability index scores for the
i=-l 20 years. On the other hand, Wainoco Oil Corporation's
where i represents the general index of n DMUs comprising largest negative mean stability index value represents robust
the industry and (YjT, Xj) is the transposed vector of outputs inefficiency and has the lowest efficiency, being in the 26th
and inputs, for a particular firm under evaluation, denoted ranking. Wainoco's high standard deviation indicates a large
as DMUj. variation in predominantly negative stability scores for the
The technical efficiency status (efficient or inefficient) for 20 years. By using this procedure, the stability index rank-
each DMU is determined by comparing its component ings, an analyst can obtain a composite measure for verifying
vector to PE. If no other component vector, observed or the performance of a particular firm as compared to other
hypothetical, in PE consumes the same or less input while firms (DMUs) in the same industry over a period of time.

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 EH Feroz et al-Financial statement analysis 57

Table 6 DEA stability index rankings by firm for oil and gas industry

Stability Mean of stability of index for Standard deviation of stability

index rankings Firm 20 years" index for 20 yearsa
8 Amerada Hess Corp 0.0298 0.1476
20 Amoco Corp -0.0014 0.0141
3 Ashland Oil Inc 0.1404 0.0545
11 Atlantic Richfield 0.0272 0.1334
16 Chevron -0.0073 0.0139
9 Crown Central 0.0286 0.0426
1 Exxon Corp 0.4117 0.0467
22 Fina Inc -0.0212 0.0163
6 Holly Corp 0.0968 0.2186
24 Kerr-McGee Corp -0.0303 0.0251
13 Louisiana Land 0.0100 0.0854
17 Mapco Inc -0.0089 0.0193
6 Mobil Corp 0.0540 0.0353
25 Murphy Oil Corp -0.0369 0.0359
12 Pennzoil Co 0.0127 0.1153
14 Phillips Petroleum 0.0061 0.0458
23 Quaker State Crop -0.0265 0.0245
15 Royal Dutch Pet -0.0004 0.0084
19 Shell Tran Trade -0.0099 0.0101
21 Sun Co Inc -0.0203 0.0188
7 Tesoro Petroleum 0.0367 0.0803
9 Texaco Inc 0.0286 0.0446
2 Tosco Corp 0.1728 0.2034
5 Total Petroleum 0.0908 0.3032
21 Unocal Corp -0.0140 0.0149
26 Wainoco Oil Corp -0.0516 0.2065

aOr less if negative equity should occur in a given

Company 20's mean is based upon 18 years (or tau
In 24 other firms the mean was based on 20 observations.

Summary and limitations statement numbers for some of the changes implemented
after the inception of the Financial Accounting Standard
In this paper we demonstrate that DEA can complement Board in 1973.
traditional accounting ratios used as a tool for financial
We believe that these results demonstrate that DEA can
statement analysis. In order to demonstrate the relevance of
complement traditional ratios as a composite tool for finan-
DEA as a tool for financial statement analysis, we revisited
the financial ratio based analysis of Davis and Peles. Our cial statement analysis, especially since it avoids the pitfalls
replication results indicate that our initial analysis is con- of the one-ratio-at-a-time approach common to ratio analy-
sistent with those of Davis and Peles so that we can establish sis. Availability of user-friendly DEA software makes this
a benchmark for comparing DEA with the accounting ratios. approach particularly attractive from the point of view of
Although our null hypothesis stipulated that there will be no financial analysts. We certainly hope that financial analysts
looking for a reliable tool of analysis will find the DEA
relationship between deviations from optimum DEA effi-
ciency scores and deviations from optimum values of approach outlined in this paper sufficiently easy to replicate
financial ratios, our results in Tables 3-5 indicate that the in a practice setting. We have demonstrated that the DEA
financial ratios provide only an ad hoc and partial evaluation approach simultaneously measures efficiency, while ratios
of firm performance. We then demonstrate how financial can only provide ad hoc or anecdotal information. Our
analysts can employ the stability index rankings to obtain a research findings indicate that DEA deviations and ratio
consistent measure of the overall performance of firm using deviations are somewhat correlated, but not in a systematic
the rest of the industry as a consistent norm. way. This indicates that DEA efficiency scores have incre-
As with other empirical research, our analysis could be mental information contents over and above the information
suffering from the time-period effects, caused by the changes generated by ratios. Future research might devise a truly
in the accounting convention (GAAP) and other macro- independent test, which would hopefully be an advancement
economic variables. A compensating factor, however, would over our somewhat modest claim that DEA can augment the
be the practice of restating earnings and relevant financial traditional ratio analysis.

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58 Journal of the Operational Research Society Vol. 54, No. 1

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(1985). Foundations of data envelopment analysis for
2 Chames A, Cooper W, Lewin A, and Seiford L (1994). Data
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JEconom 30: 91-107.
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