Technically, financial ratios can be divided into several, sometimes overlapping categories. A financial ratio is of the form X/Y, where X and Y are figures derived from the financial statements or other sources of financial information. One way of categorizing the ratios is on the basis where X and Y come from (see Foster, 1978, pp. 36-37, and Salmi, Virtanen and Yli-Olli, 1990, pp. 10-11). In traditional financial ratio analysis both the X and the Y are based on financial statements. If both or one of them comes from the income statement the ratio can be called dynamic while if both come from the balance sheet it can be called static (see ibid.). The concept of financial ratios can be extended by using other than financial statement information as X or Y in the X/Y ratio. For example, financial statement items and market based figures can be combined to constitute the ratio.
In this paper we review the existing trends in financial statement analysis literature by focusing primarily on the theoretical and empirical basis of financial ratio analysis. This is an important task to carry out since the ratios are often used intuitively, without sufficient consideration to their theoretical meaning and statistical properties. In doing this it is our purpose to pinpoint the different directions taken in quantitative ratio based research. By critically considering financial ratio literature, we also aim to help the decision makers to use ratios in an efficient way.
We review four of the research areas listed above. In our opinion the primary areas of the literature concerning the theoretical and empirical basis of financial ratio analysis are the functional form of the financial ratios, distributional characteristics of financial ratios, and classification of financial ratios. These three research avenues are reviewed in Section 2. All the major financial ratio research avenues cannot be tackled within the limited space of this paper. Therefore, we select the estimation internal rate of return from financial statements as the fourth area. A fundamental task of financial analysis is evaluating the performance of the business firm. This area, reviewed in Section 3, directly concerns profitability measurement.
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