CHAPTER II - REVIEW OF LITERATURE

In the history of FRA it is common that professional journals and academic

papers do not recognize each other. An early paper on financial ratio distributions was published
in Management Accounting by Mecimore (1968)(1). It is interesting to recognize that all
ingredients of modern distribution analysis already appear incumbent in Mecimore's paper.
Using descriptive statistical measures (average and relative deviations from the median) he
observes cross-sectional non-normality and positive skewness for twenty ratios in a sample of
randomly selected forty-four Fortune-500 firms.
The paper most often referred to in literature as the seminal paper in this field is,
however, the much later published article by Deakin (1976)(2). His chi-square findings reject
(with one exception) the normality of eleven financial ratios in a sample of 1114 Compustat
companies for 1954-72. Less extreme deviations from normality were observed when squareroot and logarithmic transformations were applied, but normality was still not supported.
Likewise, while not statistically significantly, industry grouping made the distributions less nonnormal. Concomitant results are obtained by Lee (1985) (3) using a stronger test (KolmogorovSmirnov) for a different set of data.
Bird and McHugh (1977) (4) adopt an efficient Shapiro-Wilk small-sample test for the
normality of financial ratios for an Australian sample of five ratios over six years. Like Deakin
they find in their independent study that normality is transient across financial ratios and time.
They also study the adjustment of the financial ratios towards industry means which is a different
area of FRA research. Bougen and Drury (1980) (5) also suggest non-normality based on a crosssection of 700 UK firms.
The results indicating non-normality of financial ratio distributions have led researchers
into looking for methods of restoring normality to warrant standard parametric statistical
analyses. Frecka and Hopwood (1983)(6) observe that removing outliers and applying
transformations in a large Compustat sample covering 1950-79 restored normality in the same
financial ratios as tackled by Deakin (1976) (7). They point out that if the ratios follow the gamma
distribution, the square root transformation makes the distribution approximately normal. The

gamma distribution is compatible with ratios having a technical lower limit of zero. There is,
however, a certain degree of circularity in their approach, since instead of identifying the
underlying causes of the outliers they employ a mechanistic statistical approach to identify and
remove the outliers from the tails of the financial ratio distributions.
A varying and often a considerable number of outliers has to be removed for different
financial ratios in order to achieve normality. The empirical results are supported by later papers
such as So (1987). Ezzamel, Mar-Molinero and Beecher (1987)(8) and Ezzamel and MarMolinero (1990)(9) review and replicate the earlier analyses on UK firms with a particular
emphasis on small samples and outliers, respectively. One of the avenues taken is to study new
industries. Kolari, McInish and Saniga (1989)(10) take on the distribution of financial ratios in
banking. Buckmaster and Saniga (1990)(11) report on the shape of the distributions for 41
financial ratios in a Compustat sample of more than a quarter million observations.
Foster (1978) (12) points out the outlier problem in FRA. Later, he presented in Foster
(1986)(13) a list of alternatives for handling outliers in FRA. The list includes deleting true
outliers, retaining the outlier, adjusting the underlying financial data, winsorizing that is equating
the outliers to less extreme values, and trimming by dropping the tails. Foster also puts forward
accounting, economic and technical reasons for the emergence of outliers in FRA. While
improving the statistical results trimming and transformations can pose a problem for the
theoretical rigor in FRA research. Instead of deleting or adjusting the observations McLeay
(1986a)(14) proposes using a better fitting distribution with fat tails for making statistical
inferences in FRA. He seeks for a best fitting t-distribution for a cross-section of 1634 UK and
Irish firms. Also his empirical results confirm non-normality. The best-fitting (in the maximumlikelihood sense) t-distribution varies across financial ratios (the t-distribution can be considered
a family of distributions defined by its degrees of freedom). McLeay (1986b) (15) also tackles the
choice between equally weighted and value weighted aggregated financial ratios in terms of ratio
distributions on a sample of French firms. Also the results by Martikainen (1991) (16) demonstrate
that normality can be approached by other procedures than removing outliers. In a sample of 35
Finnish firms, four ratios and fifteen years about half of the non-normal distributions became
normal if economy-wide effects were first controlled for using the so-called Accounting-index

model. Martikainen (1992)(17) uses a time-series approach to 35 Finnish firms in turn observing
that controlling for the economy factor improves normality.

Typically, many later papers tackle the same basic question of ratio distributions
using different samples and expanding on the methodologies. Buijink and Jegers (1986) (18) study
the financial ratio distributions from year to year from 1977 to 1981 for 11 ratios in Belgian
firms corroborating the results of the earlier papers in the field. Refined industry classification
brings less extreme deviation from normality. They also point to the need of studying the
temporal persistence of cross-sectional financial ratio distributions and suggest a symmetry index
for measuring it. Virtanen and Yli-Olli (1989) (19) studying the temporal behavior of financial ratio
distributions observe in Finnish financial data that the business cycles affect the cross-sectional
financial ratio distributions.
The question of the distribution of a ratio format variable (financial ratio) has been
tackled mathematically as well as empirically. Barnes (1982) (20) shows why the ratio of two
normally distributed financial variables does not follow the normal distribution (being actually
skewed) when ratio proportionality does not hold. Tippett (1990) (21) models financial ratios in
terms of stochastic processes. The interpretation in terms of implications to financial ratio
distributions are not, however, immediately evident, but the general inference is that "normality
will be the exception rather than the rule".
Because of these results bringing forward the significance of the distributional
properties of financial ratios many later papers report routinely about the distributions of
financial ratios in connection with some other main theme. Often these themes are related to
homogeneity and industry studies such as Ledford and Sugrue (1983)(22). The distributional
properties of the financial ratios also have a bearing in testing proportionality as can be seen, for
instance, in McDonald and Morris (1984)(23). In a bankruptcy study Karels and Prakash (1987)(24)
put forward that in applying the multivariate methods (like discriminant analysis) the
multivariate normality is more relevant than the (univariate) normality of individual financial

ratios. They observe that deviations from the multivariate normality are not as pronounced as the
deviations in the earlier univariate studies.
Watson (1990)(25) examines the multivariate distributional properties of four financial
ratios from a sample of approximately 400 Compustat manufacturing firms for cross-sections of
1982, 1983 and 1984. Multivariate normality is rejected for all the four financial ratios.
Multivariate normality is still rejected after applying Box's and Cox's modified power
transformations. However, when multivariate outliers are removed, normality is confirmed.

Multivariate normality has particular bearing on research using multivariate methods, for
example on bankruptcy prediction. It also has implications on univariate research, since while
univariate normality does not imply multivariate normality, the opposite is true.
Susan Ward (2008)(26) emphasis that financial analysis using ratios between key values
help investors cope with the massive amount of numbers in company financial statements. For
example, they can compute the percentage of net profit a company is generating on the funds it
has deployed. All other things remaining the same, a company that earns a higher percentage of
profit compared to other companies is a better investment option.
Jonas Elmerraji (2005) (27) tries to say that ratios can be an invaluable tool for making an
investment decision. Even so, many new investors would rather leave their decisions to fate than
try to deal with the intimidation of financial ratios. The truth is that ratios aren't that intimidating,
even if you don't have a degree in business or finance. Using ratios to make informed decisions
about an investment makes a lot of sense, once you know how use them. `

REFERENCE
1. Mecimore, C.D. (1968), "Some empirical distributions of financial ratios", Management
Accounting 50/1, 13-16.
2. Deakin, E.B. (1976), "Distributions of financial accounting ratios: some empirical
evidence", Accounting Review, January 1976, 90-96.

3. Lee, C.-W.J. (1985), "Stochastic properties of cross-sectional financial data", Journal of

Accounting Research 23/1, 213-227.
4. Bird, R.G., and McHugh A.J. (1977), "Financial ratios - an empirical study", Journal of
Business Finance and Accounting 4/1, 29-45.
5. Bougen, P.D., and Drury, J.C. (1980), "U.K. statistical distributions of financial ratios,
1975", Journal of Business Finance and Accounting 7/1, 39-47.
6. Frecka, T.J., and Hopwood, W.S. (1983), "The effects of outliers on the cross-sectional
distributional properties of financial ratios", Accounting Review 58/1, 115-128.
7. Deakin, E.B. (1976), "Distributions of financial accounting ratios: some empirical
evidence", Accounting Review, January 1976, 90-96.
8. Ezzamel, M., Mar-Molinero, C., and Beecher, A. (1987), "On the distributional properties
of financial ratios", Journal of Business Finance and Accounting 14/4, 463-481.
9. Ezzamel, M., Brodie, J., and Mar-Molinero, C. (1990), "The distributional properties of
financial ratios in UK manufacturing companies", Journal of Business Finance and
Accounting 17/1, 1-29.
10. Kolari, J., McInish, T.H., and Saniga, E.M. (1989), "A note on the distribution types of
financial ratios in the commercial banking industry", Journal of Banking and Finance
13/3, 463-471.
11. Buckmaster, D., and Saniga E. (1990), "Distributional forms of financial accounting
ratios: Pearsons's and Johnson's taxonomies", Journal of Economic and Social
Measurement 16, 149-166.
12. Foster, G. (1978), Financial Statement Analysis. Prentice-Hall, first ed.
13. Foster, G. (1986), Financial Statement Analysis. Prentice-Hall, 2nd ed.

14. McLeay, S. (1986a), "Studentst and the distribution of financial ratios", Journal of
Business Finance and Accounting 13/2, 209-222.
15. McLeay, S. (1986b), "The ratio of means, the means of ratios and other benchmarks: an
examination of characteristics financial ratios in the French corporate sector", Finance,
The Journal of the French Finance Association 7/1, 75-93.
16. Martikainen, T. (1991), "A note on the cross-sectional properties of financial ratio
distributions", Omega 19/5, 498-501.
17. Martikainen, T. (1992), "Time-series distributional properties of financial ratios:
empirical evidence from Finnish listed firms", European Journal of Operational Research
58/3, 344-355.
18. Buijink, W., and Jegers, M. (1986), "Cross-sectional distributional properties of financial
ratios in Belgian manufacturing industries: aggregation effects and persistence over
time", Journal of Business Finance and Accounting 13/3, 337-363.
19. Virtanen, I., and Yli-Olli, P. (1989), "Cross-sectional and time-series persistence of
financial ratio distributions; Empirical evidence with Finnish Data", European Institute
for Advanced Studies in Management, Working paper 89-04, Brussels.
20. Barnes, P. (1982), "Methodological implications of non-normally distributed financial
ratios", Journal of Business Finance and Accounting 9/1, 51-62.
21. Tippet, M. (1990), "An induced theory of financial ratios", Accounting and Business
Research 21/81, 77-85.
22. Ledford, M.H., and Sugrue, P.K. (1983), "Ratio analysis: application to U.S. motor
common carriers", Business Economics, September 1983, 46-54.
23. McDonald, B., and Morris, M.H. (1984), "The statistical validity of the ratio method in
financial analysis: an empirical examination", Journal of Business Finance and
Accounting 11/1, 89-97.

24. Karels, G.V., and Prakash, A.J. (1987), "Multivariate normality and forecasting of
business bankruptcy", Journal of Business Finance and Accounting 14/4, 573-593.
25. Watson, C.J. (1990), "Multivariate distributional properties, outliers, and transformation
of financial ratios", Accounting Review 65/3, 682-695.
26. Susan Ward (2008), Article Financial Ratio Analysis for Performance Check.
27. Jonas Elmerraji (2005), Article Analyze Investments Quickly With Ratios