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Modelling the Longitudinal Properties of Financial Ratios of European Firms

  • Stuart McLeay
  • Maxwell Stevenson
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    The use of financial ratios by analysts to compare the performance of firms from one accounting period to the next is of growing importance with continued European economic integration. Recent studies suggest that the individual component series of financial ratios exhibit nonstationarity which is not eliminated by the ratio transformation. In this paper, w e derive a generalised model that incorporates stochastic and deterministic trends and allows for restricted and unrestricted proportionate growth in the ratio numerator and denominator. When the individual firm series are included in a panel structure with large N and small T, we are unable to reject convincingly a joint hypothesis of nonstationarity, whilst in about one third of the individual firm panels there is no evidence of a unit root. Although the components of financial ratios are correlated variables, our estimates show that any cointegrating effects decay rapidly.

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    Paper provided by IIIS in its series The Institute for International Integration Studies Discussion Paper Series with number iiisdp184.

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    Date of creation: 16 Nov 2006
    Date of revision:
    Handle: RePEc:iis:dispap:iiisdp184
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    1. Lev, Baruch & Sunder, Shyam, 1979. "Methodological issues in the use of financial ratios," Journal of Accounting and Economics, Elsevier, vol. 1(3), pages 187-210, December.
    2. Michael Binder & Cheng Hsiao & M. Hashem Pesaran, 2000. "Estimation and Inference In Short Panel Vector Autoregressions with Unit Roots And Cointegration," CESifo Working Paper Series 374, CESifo Group Munich.
    3. Christos Ioannidis & David A. Peel & Michael J. Peel, 2003. "The Time Series Properties of Financial Ratios: Lev Revisited," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 30(5-6), pages 699-714.
    4. David Ashton & Paul Dunmore & Mark Tippett, 2004. "Double Entry Bookkeeping and the Distributional Properties of a Firm's Financial Ratios," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 31(5-6), pages 583-606.
    5. Pasaran, M.H. & Im, K.S. & Shin, Y., 1995. "Testing for Unit Roots in Heterogeneous Panels," Cambridge Working Papers in Economics 9526, Faculty of Economics, University of Cambridge.
    6. Gallizo, Jose L. & Salvador, Manuel, 2003. "Understanding the behavior of financial ratios: the adjustment process," Journal of Economics and Business, Elsevier, vol. 55(3), pages 267-283.
    7. Stuart McLeay, 1997. "Boundary Conditions for Ratios with Positively Distributed Components," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 24(1), pages 67-84.
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