The Ratio Dependence Problem in Financial Ratio Analysis for Small Firms: An Australian Perspective

Abstract

Ratios determined from their financial records are often used to measure and monitor the performance of small firms. Understanding the nature of these ratios and possible problems in their computation and interpretation is a critical issue in the small firm domain. For example, the comparability of research studies demands a certain degree of constancy in variable definition and the interpretation of results. Also, developing assistance possibilities through public policy initiatives or advisory practice requires access to accurate and comparable sources of information. Studies using factor analysis to select ratios from multi-business data bases have found that the number of factors may differ between data sets and that long-term stability may be questionable. Such differences give rise to the research question analysed in this paper - are the most commonly used predetermined ratios used in research and practice environments an independent set of ratios with respect to the data from which they are determined? Factor analysis of the financial records of 3,986 Australian firms reduced an initial cohort of fifty-four ratios into eighteen independent factors. The null hypothesis that each of the six principal ratios most frequently used in research and in practice is an independent representative of one and only one factor is rejected. These results reinforce the need in studies of small firms to use factor analysis or other statistical approaches to determine independent factors rather than relying on a universal and predetermined set of ratios.