AN EMPIRICAL EVALUATION OF THE COLLINEARITY ANDCORRELATION OF FINANCIAL RATIOS IN BUSINESS

ORGANISATIONS

ByTHANKGOD C. AGWOR

Department of AccountancyRivers State University of Science and Technology

Port Harcourt

ANDDISON CONTINUE EKETUPostgraduate Unit

Department of ManagementRivers State University of Science and Technology

Port Harcourt

And

FYNEFACE N. AKANIDepartment of Accountancy

University of Port HarcourtChoba

ABSTRACT

Financial ratios are assumed to be very usefulpredictors of business performance, growth andfinancial status. This study evaluates the cohlinearityand correlation of financial ratios to establish apattern of relationship that could serve s nempirically supported guide for financial ratiosreliance in business evaluation decisions. The researchdata were gathered from the annual account report of

vita foam Plc and analyzed using collinearity andcorrelation to test the research propositions. Thepaper found the existence of correlation andcollinearity in the financial ratios, and concludesthat financial ratios are reliable business statusindicators. We therefore recommend the application offinancial ratios in the evaluation of businessperformance, growth and financial strength.

INTRODUCT IONThe usefulness of business financial ratios appearsto be widely accepted by financial analysts,business analysts, shareholders, creditors, andother allied stakeholders in business. This is sobecause such business dynamic and critical elementsas performance, growth, and financial status areeasily understood from the financial ratiosanalysis. Unfortunately, in most cases where suchindicators are relied upon, there are yet contrarymanifestations. For instance, the financial ratiosof most distress banks and businesses were positiveprior to their doom. The issue then has been thequestion of the reliability of financial ratios asindicators of business growth, performance, andfinancial status. Thus, the paper critically andempirically analyses the collinearity andcorrelation of financial ratios to evaluate theirreliability. The paper therefore extricates theconstituent elements of financial ratios,distribution of financial ratios, correlationsbetween ratios, and collinearity between ratios.

LITERATURE REVIEW

Financial ratios take the following structure:profitability, liquidity, debt, and activitycompartments. Considering the validity of theseindices, there appears to be a logical agreementamong Agundu(2005); Anthony andGovindarajain( 1995); Pandey(2000); andO’Connor( 1973) that financial ratios are veryuseful indicators for understanding a business’wellbeing. Profitability ratios are derived frommargin on sales and turnover of capital employed(Pandey, 2005; Agundu, 2005). Therefore,profitability ratios consist of return on capitalemployed. (ROCE)-measure of output to resourcesused; margin on sales (MOS)- measures volume ofsales and amount of costs incurred; turnover oncapital employed (TCE) — measures the effectivemanagement of the use of resources; and return onequity(ROE) — measures the profit of shareholdersfrom their investment (Whithington, 1999; Olaseni,1998; and Agundu2005).

ACTIVITY RATIOSActivity ratios measure cash and debtors returns onstock. Therefore, its components are: stock anddebtors turnover. The turnover of stock istechnically the coefficient of stock value at theend of a year and the cost of sales for the year.Therefore, it measures the number of times stocksare turned over in each year. The implication ofthe ratio is that high coefficient valve representsefficient stock management, while lower coefficientindicates inefficient stock management. However,the debts turnover component of activity ratio

tends to measure the volume of fund held in debtand time taken to recover such. In the calculationof its coefficience, the average sales per calendarday are divided by the debtors at the end of theperiod. The implication of this measure is thedetermination of the value of sale held in debt(Wright, 1995; Pandey, 2000; and Awokeni 2003).

LIQUIDITY RATIOSLiquidity ratios are the most frequently used ratioas it shows the ability of the business to meet itsfinancial obligation or its commitments to itsthird parties. Liquidity ratios are measured incurrent ratio, and quick or acid test ratios, thecurrent ratio show how current assets can settlecurrent liabilities. Considering the implication ofthis currency, Wright (1995) argues that, “theremust be sufficient long-term funds to cover long-term assets with enough left over to cover thenecessary margin between current assets and currentliabilities to provide the required ratio”.However, the quick or acid test ratio is concernedwith the ease at which assets can be converted tocash to settle liabilities. As such its differencefrom the current ratio is the exclusion of stockand prepaid expenses (Pandey, 2000 Van Hon, 2007).

FINANCING RATIOSFinancing ratios consist of gearing or debt equityratio, and proprietary ratio. The former seek thecoefficient of fixed interests, loans, andredeemable preference share; and book value ofequity. The implication of the gearing ratio restson it the business dependency on fixed interest

loans in its operation. Therefore the lower itscoefficient the preferable it is. On theproprietary ratio, the measure is the degree ofprotection of unprotected creditors in the event ofbusiness failure. Therefore, it is the coefficientof shareholders fund and total tangible assets(Awokeni, 2003, Pandey 2000).

INVESTORS’ RATIOSThe investors’ ratios measures Earnings Per Share(EPS); Price/earning ratio (PIE); time cover; anddividend yield. The EPS is the coefficient ofinvestors’ earnings by the number of ordinaryshares issued. E/P is the coefficient of currentmarket price of the company and its EPS. Timescover expresses the number of times the availableearnings cover the cost of the dividend. Byimplication, it is the coefficient of profit aftertax and ordinary share dividends. Similarly, thedividend yield expresses the expected grass returnof an investor at current market share price.

RELATION BETWEEN RATIOSIn tests for correlation, Olaseni(1998), rank (i)current and acid test, (ii) inventory and assetturnover, (iii) current ratio and profit margin,(iv) debtequity and current ratios. For ratioswithin the same category, he discovered a highcorrelation between the acid test and currentratio. A moderate correlation was found between theinventory and asset turnover ratios. And for ratiosthat are in different categories, he found a lowcorrelation between the profit margin ratio(profitability category) and the current ratio

(liquidity category). A negative correlationbetween the current ratio (liquidity category) andthe debt-equity ratio (leverage category) was alsofound.

On the correlations between ratios, Bird and McHugh(1976) found ratios to be highly corrected overtime. They concluded that:

it is to be expected that ratios classified withindifferent categories will generally yielddifferent types of information about a firm and,they should often exhibit fairly low correlationover time, whereas ratios within the same categoryare expected to be fairly high correlation (p.61).

They found a high positive correlation between (a)the quick ratio and working capital ratio and (b)the efficiency ratio and the after-taxprofitability ratio. The financial leverage ratioand the working capital ratio, both from twodifferent ratio groups were found to be negativelycorrelated.

COLLINEARITY OF FINANCIAL RATIOSSince items in the accounting statements tend tomove in the same direction as others, an more orless proportionately, it is believed thatcollinearity is always present (Horrigan, 1965).Bird and Mcl-lugh (1977) also shared this beliefwhen they wrote:

…the value of information that attaches to anadditional ratio given one readily knowsseveral other ratios, is a decreasing function

of the magnitude of correlation between theadditional ratio and the known ratios (p.1 8).

Similarly, Pindyck and Rubinfield (981), arguedthat the distribution of variables are quitesensitive to multicollinearity and that this willlead to an incorrect interpretation of thecoefficient of the predictor variables in themodel. Thus, this provides a justification for theuse of one ratio in each category of ratios.Collinearity in some ratios implies that we shoulddrop one or more of the collinear variables toimprove the quality of the model (Olaseni 1998).Firms conduct their activities based on profitmotive. Any activity that increases cost but doesnot increase revenue is abandoned. For example,when firms incur current liabilities, it isexpected that there are enough current assets toback liabilities. It therefore, seems reasonable toassume that there is a relationship between thevariables that define a financial ratio.

METHODOLOGYThe paper adopts a nomothetic method to analysesecondary data on financial ratios generated fromthe annual accounts of vita foam plc. Thecoilnearity and correlation statistical model areused to analyse the research data. The coefficientof the collinearity and correlation method appliedare the basis of acceptability or otherwise of theresearch proposition.

Research Propositions (RP):

RP1: There is no significant correlation betweenratios in the

same category and ratios in differentcategories

RP2: The variables defining a financial ratios arenot significantly collinear.TABLE 1: FINANCIAL RATIO DATA (1991-2000)

Source: computed from research data 2007.

ANALYSIS FOR COLLINEARITYThe argument here is that items in the accountingstatements tend to move in the same direction asothers, and more or less proportionately, so thatcollinearity is always present. Firms conduct theiractivities based on profit motive. Any activitythat increases cost but does not increase revenueis abandoned. For example, when firms incur currentliabilities, it is expected that there are enoughcurrent assets to back liabilities. It therefore,seems reasonable to assume that there is a

relationship between the variables that define afinancial ratio. It is believed that the presenceof collinearity in financial ratio is the basis ofthe normality assumption. This indicates that toimprove the quality of the model, one or more groupof variables defining a financial ratio could bedropped or maneuvered. The coefficient ofregression (beta), the coefficient of determination(r2), the standard error of estimate (Se), the t-statistic are computed and presented in Table 2.( 5CC data specifications for collnearity of ratiosin appendix 1) The decision rule is that if thecomputed ‘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 thatcollinearity is always present in financial ratios.It is often argued since the normality assumptionis found on the fact that financial ratios arecollinear, it is reasonable to advance thatcollinearity implies normality. In other words, ifeach of the financial ratios investigated arenormal, and collinear, then, collinearity impliesnormality. This decision rule is derived frommathematical 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 RELATIONSHIPBETWEEN VARIABLES DEFINING A FINANCIAL RATIO

Legend: S Significant

ANALYSIS FOR CORRELATIONThe argument advanced in this section is thatratios classified within the same category willyield a fairly high correlation coefficient,whereas, ratios classified within differentcategories will generally exhibit fairly lowcorrelation overtime. In order to test for intra-category, correction, the spearman’s rankcorrelation coefficient is computed and hence, thet-test statistic. The decision rule is to rejectH02 if the computed ‘t’ is greater than thetabulated ‘t’.

The data on Table 3 indicates that each of thefinancial ratios investigated are highly correlatedover time, within the same category. There is avery strong negative correlation between the debtequity ratio and proprietary ratio. A substantialnegative association was found between stockturnover and asset turnover. A very strong positiveassociation was also found between the margin onsale and return on capital employed. A substantialpositive association was discovered between thecurrent ratio and acid-test ratio.

Overall, HO2 is rejected, leading to the conclusionthat ratios within the same category are correlatedover time. For inter category correlation, a lowpositive correlation was found between margin onsales (profitability group) and current ratio(liquidity group). There was a low negativeassociation between debt-equity ratio (financialgroup) and current ratio (liquidity group). Therewas a negligible negative association betweenreturn on capital employed (profitability) andasset turnover (activity). However, for currentratio and stock turnover, there was a moderatenegative association and for proprietary ratio andacid test ratio, the negative association wassubstantial. Overall, the association betweenratios from different category, is not significant.

TABLE: 3: INTRA-CATEGORY CORRELATION RESULTOF RATIOS INVESTIGATED

Legend: S significant

TABLE: 4: INTER-CATEGORY CORRELATION RESULT OFRATIOS INVESTIGATED

Legend: N/S — Not significant

FINDINGS, CONCLUSIONS AND RECOMMENDATIONThe study reveals that collinearity is alwayspresent in financial ratios. This confirms the viewthat accounting statements tend to move in the samedirection as others, either more or lessproportionately. It is therefore valid thatcollinearity implies normality. This was also thefindings of Beaver (1967). It was discovered thatratios in the same category produce fairly highcorrelation coefficients whereas ratios indifferent categories produce fairly low correlationcoefficients. This implies that:1. It is valid to compare a financial ratio with a

norm, or determine the relative position of acompany within and industry because of thepresence of the normality assumptions. Failurepredictor model can utilize financial ratios asinput as they are normally distributed.

2, Parametric statistical techniques applies tofinancial ratiodata.

3. It is valid to make mathematical computationsto estimate the unknowns using financial ratiosbecause of the presence of collinearity.

4. Finally, financial ratios should be groupedinto classes to produce similar information Thepresence of fairly high correlationcoefficients within categories indicate that itis valid to manipulate one ratio components toimprove the components in different groups asreveals by fairly low correlation coefficients.

The financial ratios are collinear with highcorrelations from ratios in the same category.Thus, we recommend that:

1. Financial analysts can validly compare afinancial ratio with a norm, or determine therelative position of a company within anindustry.

2. Financial ratios should be used as data-inputsfor failure\growth predicator models.

3. Researchers can now use parametric test onfinancial ratio data.

4. A financial ratio may be used as a basis forestimatingunknowns. Thus, financial ratios are usefulinputs inregression and multiple di,scriminant analysis.

5. Management can manipulate a ratio component toimprove the other provided they are in the samegroup.

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