Modelling the longitudinal properties of financial ratios

Abstract

Previous studies provide conflicting evidence on the time series properties of company financial ratios, claiming either that the components of ratios exhibit nonstationarity which is not eliminated by the ratio transformation, or that a unit root in the components may be rejected which implies strong persistence in their ratio. In this article, a generalized model is derived that incorporates stochastic and deterministic trends and allows also for restricted and unrestricted proportionate growth in the ratio numerator and denominator. When the individual firm series are included in a panel analysis for large N and small T, this study is unable to reject convincingly a joint hypothesis of nonstationarity. However, the ratio variables are shown to be cointegrated, which can lead to stationarity in the ratio itself. Furthermore, evidence of cotrending provides support for a parsimonious model, where the financial ratio varies lognormally around its expected value.

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