Ratio Analysis

A preponderance of evidence suggests that since the late 1800s, ratio analysis has been

widely used in the analysis and valuation of published financial data. During much of this time,

security analysis firms (e.g., Dun & Bradstreet) have published, and presumably have profited from

publishing, listings of annual financial ratio values for various firms and industries. The literature

on financial statement analysis, as well as accounting and finance textbooks, emphasizes the use of

ratio analysis. Additionally, auditors are now required under SAS No. 56, Analytical Procedures,

to use analytical procedures in the planning and final review stages of a financial statement audit.

Ratio analysis is an analytical procedure that can assist the auditor in evaluating the reasonableness

of financial statement amounts. The demand for financial ratio data provides some supportive

evidence of the utility of this information.

Ratios derived from financial statements are used extensively by both practitioners and

researchers (Gibson, 1982; Whittington, 1980). Whittington (1980) identified two principal uses

of financial ratios: "the traditional, normative use of the measurement of a firm's ratio compared

with a standard (usually an industry norm), and the positive use in estimating empirical

relationships, usually for purposes of prediction." This positive use of financial ratios has typically

been of two types: (1) by accountants and analysts in evaluating firm performance and forecasting

future financial variables for the firm, and (2) by researchers in statistical models for mainly

predictive purposes, such as bankruptcy prediction (Altman, 1968; Ohlson, 1980), credit rating

(Pinches & Mingo, 1973), security analysis (Reilly, 1986), audit evaluation (Altman & McGough,

1974), assessment of risk (Beaver, 1966), identification of the characteristics of takeover targets

(Rege, 1984; Belkaoui, 1978), and the assessment of the incremental information content of

earnings- and nonearnings-based financial ratios (Hopwood & Schaefer, 1988).

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