An Induced Theory of Financial Ratios

Abstract

In recent years, a considerable volume of research has emerged on the analytical, empirical and statistical properties of financial ratios. In the present paper the methods of continuous time stochastic calculus are applied to the modelling of financial ratios. Two standard stochastic processes are examined and applied, namely the geometric Brownian motion and the elastic random walk. The properties of aggregate or ‘industry ratios’ and the reasonableness or otherwise of the ‘proportionality assumption’ are also examined. Typically, the approach of this paper implies that accounting ratios will be non-linear functions of time and normality will be the exception rather than the rule.

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