4. Conclusion

In this paper we review four areas of financial ratio analysis research: It is obvious that the existing main research areas in financial ratio analysis are fairly separate from each other sometimes with traditions of their own. Historically, these trends have developed to a degree on their own without a distinct theoretical framework to encompass the entire field of financial statement analysis. Of the four areas reviewed in this paper only the first and the second are closely interrelated.

The research on the functional form of financial ratios has been characterized by theoretical discussions about the ratio format in financial ratio analysis and empirical testing of the ratio model. We conclude from the review that the proportionality assumption for financial ratios is stronger within an industry than between industries. Moreover, proportionality varies from ratio to ratio, and between time periods indicating problems in temporal stability.

The research on the distributional characteristics of financial ratios has focused much on the question of normality of the financial ratio distributions because normality would be very convenient in statistical analysis. The empirical results, however, indicate that in many cases the financial ratios follow other than the normal distribution. Part of the research has sought to restore normality by transformations of the data or by eliminating outlier observations. Some improvement towards normality has been observed, but in many cases it has been inadequate.

The research on classifying financial ratios into parsimonious sets can be in our opinion best characterized as the following trends: pragmatical empiricism, deductive approach, inductive approach, and confirmatory approach. The review shows that the number of essential financial ratios often can be reduced to about 4-7 essential ratios. However, empirically based categorizations are not stable across the different studies, that is there is no clear consensus what the categories are, except that profitability and solidity commonly appear. This dispersion of the inductive empirical results has given rise to using theoretical classifications and then seeking empirical confirmation of a priori classifications. The most prevalent method has been factor analysis, although also other options have been used.

The fourth area we reviewed was the estimation of internal rate of return from financial statements. The discussions center on three trends, the relationship between IRR and ARR, the usage of CRR for IRR estimation, and direct estimation of IRR from the financial statements. This area is characterized by much debate both on the concepts of economists' and accountants' views, and the validity of both the theoretical and empirical results. No unique consensus whether successful IRR estimation is possible has been reached in the literature.

A common feature of all the areas of financial ratio analysis research seems to be that while significant regularities can be observed, they are not necessarily stable across the different ratios, industries, and time periods. Thus there remains much to be done to find a tenable theoretical background to improve the generalizability of financial ratio analysis. A systematic framework of financial statement analysis along with the observed separate research trends might be useful for furthering the development of research. If the research results in financial ratio analysis are to be useful for the decision makers, the results must be theoretically consistent and empirically generalizable.


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Department of Accounting and Finance, University of Vaasa,
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