AN EMPIRICAL EVALUATION OF THE COLLINEARITY AND CORRELATION OF FINANCIAL RATIOS IN BUSINESS ORGANISATIONS

Transcription

1 Rivers State University of Science And Technology, Nigeria From the SelectedWorks of ThankGod C Agwor Dr 2006 AN EMPIRICAL EVALUATION OF THE COLLINEARITY AND CORRELATION OF FINANCIAL RATIOS IN BUSINESS ORGANISATIONS ThankGod C Agwor, Dr Available at:

2 AN EMPIRICAL EVALUATION OF THE COLLINEARITY AND CORRELATION OF FINANCIAL RATIOS IN BUSINESS ORGANISATIONS By THANKGOD C. AGWOR Department of Accountancy Rivers State University of Science and Technology Port Harcourt ANDDISON CONTINUE EKETU Postgraduate Unit Department of Management Rivers State University of Science and Technology Port Harcourt And FYNEFACE N. AKANI Department of Accountancy University of Port Harcourt Choba ABSTRACT Financial ratios are assumed to be very useful predictors of business performance, growth and financial status. This study evaluates the cohlinearity and correlation of financial ratios to establish a pattern of relationship that could serve s n empirically supported guide for financial ratios reliance in business evaluation decisions. The research data were gathered from the annual account report of vita foam Plc and analyzed using collinearity and correlation to test the research propositions. The paper found the existence of correlation and collinearity in the financial ratios, and concludes that financial ratios are reliable business status indicators. We therefore recommend the application of financial ratios in the evaluation of business performance, growth and financial strength.

3 INTRODUCT ION The usefulness of business financial ratios appears to be widely accepted by financial analysts, business analysts, shareholders, creditors, and other allied stakeholders in business. This is so because such business dynamic and critical elements as performance, growth, and financial status are easily understood from the financial ratios analysis. Unfortunately, in most cases where such indicators are relied upon, there are yet contrary manifestations. For instance, the financial ratios of most distress banks and businesses were positive prior to their doom. The issue then has been the question of the reliability of financial ratios as indicators of business growth, performance, and financial status. Thus, the paper critically and empirically analyses the collinearity and correlation of financial ratios to evaluate their reliability. The paper therefore extricates the constituent elements of financial ratios, distribution of financial ratios, correlations between ratios, and collinearity between ratios. LITERATURE REVIEW Financial ratios take the following structure: profitability, liquidity, debt, and activity compartments. Considering the validity of these indices, there appears to be a logical agreement among Agundu(2005); Anthony and Govindarajain( 1995); Pandey(2000); and O Connor( 1973) that financial ratios are very useful indicators for understanding a business wellbeing. Profitability ratios are derived from margin on sales and turnover of capital employed (Pandey, 2005; Agundu, 2005). Therefore, profitability ratios consist of return on capital employed. (ROCE)-measure of output to resources used; margin on sales (MOS)- measures volume of sales and amount of costs incurred; turnover on capital employed (TCE) measures the effective management of the use of resources; and return on equity(roe) measures the profit of shareholders from their investment (Whithington, 1999; Olaseni, 1998; and Agundu2005).

4 ACTIVITY RATIOS Activity ratios measure cash and debtors returns on stock. Therefore, its components are: stock and debtors turnover. The turnover of stock is technically the coefficient of stock value at the end of a year and the cost of sales for the year. Therefore, it measures the number of times stocks are turned over in each year. The implication of the ratio is that high coefficient valve represents efficient stock management, while lower coefficient indicates inefficient stock management. However, the debts turnover component of activity ratio tends to measure the volume of fund held in debt and time taken to recover such. In the calculation of its coefficience, the average sales per calendar day are divided by the debtors at the end of the period. The implication of this measure is the determination of the value of sale held in debt (Wright, 1995; Pandey, 2000; and Awokeni 2003). LIQUIDITY RATIOS Liquidity ratios are the most frequently used ratio as it shows the ability of the business to meet its financial obligation or its commitments to its third parties. Liquidity ratios are measured in current ratio, and quick or acid test ratios, the current ratio show how current assets can settle current liabilities. Considering the implication of this currency, Wright (1995) argues that, there must be sufficient long-term funds to cover long-term assets with enough left over to cover the necessary margin between current assets and current liabilities to provide the required ratio. However, the quick or acid test ratio is concerned with the ease at which assets can be converted to cash to settle liabilities. As such its difference from the current ratio is the exclusion of stock and prepaid expenses (Pandey, 2000 Van Hon, 2007). FINANCING RATIOS Financing ratios consist of gearing or debt equity ratio, and proprietary ratio. The former seek the coefficient of fixed interests, loans, and redeemable preference share; and book value of equity. The implication of the gearing ratio rests on it the business dependency on fixed interest loans in its

5 operation. Therefore the lower its coefficient the preferable it is. On the proprietary ratio, the measure is the degree of protection of unprotected creditors in the event of business failure. Therefore, it is the coefficient of shareholders fund and total tangible assets (Awokeni, 2003, Pandey 2000). INVESTORS RATIOS The investors ratios measures Earnings Per Share (EPS); Price/earning ratio (PIE); time cover; and dividend yield. The EPS is the coefficient of investors earnings by the number of ordinary shares issued. E/P is the coefficient of current market price of the company and its EPS. Times cover expresses the number of times the available earnings cover the cost of the dividend. By implication, it is the coefficient of profit after tax and ordinary share dividends. Similarly, the dividend yield expresses the expected grass return of an investor at current market share price. RELATION BETWEEN RATIOS In tests for correlation, Olaseni(1998), rank (i) current and acid test, (ii) inventory and asset turnover, (iii) current ratio and profit margin, (iv) debtequity and current ratios. For ratios within the same category, he discovered a high correlation between the acid test and current ratio. A moderate correlation was found between the inventory and asset turnover ratios. And for ratios that are in different categories, he found a low correlation between the profit margin ratio (profitability category) and the current ratio (liquidity category). A negative correlation between the current ratio (liquidity category) and the debt-equity ratio (leverage category) was also found. On the correlations between ratios, Bird and McHugh (1976) found ratios to be highly corrected over time. They concluded that: it is to be expected that ratios classified within different categories will generally yield different types of information about a firm and, they should often exhibit fairly low correlation over time, whereas ratios within the same category are expected to be fairly high correlation (p.61).

6 They found a high positive correlation between (a) the quick ratio and working capital ratio and (b) the efficiency ratio and the after-tax profitability ratio. The financial leverage ratio and the working capital ratio, both from two different ratio groups were found to be negatively correlated. COLLINEARITY OF FINANCIAL RATIOS Since items in the accounting statements tend to move in the same direction as others, an more or less proportionately, it is believed that collinearity is always present (Horrigan, 1965). Bird and Mcl-lugh (1977) also shared this belief when they wrote: the value of information that attaches to an additional ratio given one readily knows several other ratios, is a decreasing function of the magnitude of correlation between the additional ratio and the known ratios (p.1 8). Similarly, Pindyck and Rubinfield (981), argued that the distribution of variables are quite sensitive to multicollinearity and that this will lead to an incorrect interpretation of the coefficient of the predictor variables in the model. Thus, this provides a justification for the use of one ratio in each category of ratios. Collinearity in some ratios implies that we should drop one or more of the collinear variables to improve the quality of the model (Olaseni 1998). Firms conduct their activities based on profit motive. Any activity that increases cost but does not increase revenue is abandoned. For example, when firms incur current liabilities, it is expected that there are enough current assets to back liabilities. It therefore, seems reasonable to assume that there is a relationship between the variables that define a financial ratio. METHODOLOGY The paper adopts a nomothetic method to analyse secondary data on financial ratios generated from the annual accounts of vita foam plc. The coilnearity and correlation statistical model are used to analyse the research data. The coefficient of the

7 collinearity and correlation method applied are the basis of acceptability or otherwise of the research proposition. Research Propositions (RP): RP1: There is no significant correlation between ratios in the same category and ratios in different categories RP2: The variables defining a financial ratios are not significantly collinear. TABLE 1: FINANCIAL RATIO DATA ( ) Source: computed from research data ANALYSIS FOR COLLINEARITY The argument here is that items in the accounting statements tend to move in the same direction as others, and more or less proportionately, so that collinearity is always present. Firms conduct their activities based on profit motive. Any activity that increases cost but does not increase revenue is abandoned. For example, when firms incur current liabilities, it is expected that there are enough current assets to back liabilities. It therefore, seems reasonable to assume that there is a relationship between the variables that define a financial ratio. It is believed that the presence of collinearity in financial

8 ratio is the basis of the normality assumption. This indicates that to improve the quality of the model, one or more group of variables defining a financial ratio could be dropped or maneuvered. The coefficient of regression (beta), the coefficient of determination (r 2 ), the standard error of estimate (Se), the t- statistic are computed and presented in Table 2.( 5CC data specifications for collnearity of ratios in appendix 1) The decision rule is that if the computed t is greater than the tabulated t, reject HO1 and H02. The data on Table I and 2, indicate that HO1 and H02 should be rejected. The conclusion is that collinearity is always present in financial ratios. It is often argued since the normality assumption is found on the fact that financial ratios are collinear, it is reasonable to advance that collinearity implies normality. In other words, if each of the financial ratios investigated are normal, and collinear, then, collinearity implies normality. This decision rule is derived from mathematical logic that states: if p is true, and q is also true, then, p and q are both true (see: Avwokeni, 1999:117). TABLE 2: REGRESSION RESULTS OF THE RELATIONSHIP BETWEEN VARIABLES DEFINING A FINANCIAL RATIO Legend: S Significant ANALYSIS FOR CORRELATION The argument advanced in this section is that ratios classified within the same category will yield a fairly high correlation coefficient, whereas, ratios classified within different categories will generally exhibit fairly low correlation overtime. In order to test for intra-category, correction, the spearman s rank correlation coefficient is computed and hence, the t-test

9 statistic. The decision rule is to reject H02 if the computed t is greater than the tabulated t. The data on Table 3 indicates that each of the financial ratios investigated are highly correlated over time, within the same category. There is a very strong negative correlation between the debt equity ratio and proprietary ratio. A substantial negative association was found between stock turnover and asset turnover. A very strong positive association was also found between the margin on sale and return on capital employed. A substantial positive association was discovered between the current ratio and acid-test ratio. Overall, HO2 is rejected, leading to the conclusion that ratios within the same category are correlated over time. For inter category correlation, a low positive correlation was found between margin on sales (profitability group) and current ratio (liquidity group). There was a low negative association between debt-equity ratio (financial group) and current ratio (liquidity group). There was a negligible negative association between return on capital employed (profitability) and asset turnover (activity). However, for current ratio and stock turnover, there was a moderate negative association and for proprietary ratio and acid test ratio, the negative association was substantial. Overall, the association between ratios from different category, is not significant. TABLE: 3: INTRA-CATEGORY CORRELATION RESULT OF RATIOS INVESTIGATED Legend: S significant

10 TABLE: 4: INTER-CATEGORY CORRELATION RESULT OF RATIOS INVESTIGATED Legend: N/S Not significant FINDINGS, CONCLUSIONS AND RECOMMENDATION The study reveals that collinearity is always present in financial ratios. This confirms the view that accounting statements tend to move in the same direction as others, either more or less proportionately. It is therefore valid that collinearity implies normality. This was also the findings of Beaver (1967). It was discovered that ratios in the same category produce fairly high correlation coefficients whereas ratios in different categories produce fairly low correlation coefficients. This implies that: 1. It is valid to compare a financial ratio with a norm, or determine the relative position of a company within and industry because of the presence of the normality assumptions. Failure predictor model can utilize financial ratios as input as they are normally distributed. 2, Parametric statistical techniques applies to financial ratio data. 3. It is valid to make mathematical computations to estimate the unknowns using financial ratios because of the presence of collinearity. 4. Finally, financial ratios should be grouped into classes to produce similar information The presence of fairly high correlation coefficients within categories indicate that it is valid to manipulate one ratio components to improve the

11 components in different groups as reveals by fairly low correlation coefficients. The financial ratios are collinear with high correlations from ratios in the same category. Thus, we recommend that: 1. Financial analysts can validly compare a financial ratio with a norm, or determine the relative position of a company within an industry. 2. Financial ratios should be used as data-inputs for failure\growth predicator models. 3. Researchers can now use parametric test on financial ratio data. 4. A financial ratio may be used as a basis for estimating unknowns. Thus, financial ratios are useful inputs in regression and multiple di,scriminant analysis. 5. Management can manipulate a ratio component to improve the other provided they are in the same group. REFERENCES Agundu, P U C (2005) Finance Finnese, Port Harcourt: Out Reach Publication. Alder, H. L. and Roessler, E. B. (1999) Introduction to Probability and Statistics, San Francisco: W. H. Freeman and Company. Avwokeni, A. J. (1999).Easy Way Mathematics for Economics and Business Students. Port Harcourt, Nigeria: Pam Unique Publishing Company. Beaver, W. H. (1967) Financial Ratios as Predictors of Failure, Journal of Accounting Research 16 (3),

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13 Pindyck and Rubinfield (1981) Collinearity of Financial Ratios in a Distribution. Journal of Business Finance and Accounting 16(2), Pandey, I. M (1993) Financial Management. New Delhi, India: Vikas Publishing House PVT Ltd. Stafford Statistics for Psychologists, New York: Holt, Rinehart, and Winston. Wright, M. G. (1976) The Director Guide to Accounting and Finance. England, U. K: McGraw-I-{ill Book Company. Whittington, G. (1980) Some Basic Properties of Accounting Ratios. Journal of Business Finance and Accounting (Summer), pp

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