The Time Series Properties of Financial Ratios: Lev Revisited

16 Pages Posted: 24 Sep 2003

See all articles by Christos Ioannidis

Christos Ioannidis

University of Bath-Department of Economics

David A. Peel

Lancaster University - Management School

Michael J. Peel

Cardiff University - Cardiff Business School

Abstract

This paper re-evaluates the time series properties of financial ratios. It presents new empirical analysis which explicitly allows for the possibility that financial ratios can be characterized as non-linear mean-reverting processes. Financial ratios are widely employed as explanatory variables in accounting and finance research with applications ranging from the determinants of auditors' compensation to explaining firms' investment decisions. An implicit assumption in this empirical work is that the ratios are stationary so that the postulated models can be estimated by classical regression methods. However, recent empirical work on the time series properties of corporate financial ratios has reported that the level of the majority of ratios is described by non-stationary, (1), integrated processes and that the ratio differences are parsimoniously described by random walks. We hypothesize that financial ratios may follow a random walk near their target level, but that the more distant a ratio is from target, the more likely the firm is to take remedial action to bring it back towards target. This behavior will result in a significant size distortion of the conventional stationarity tests and lead to frequent non-rejection of the null hypothesis of non-stationarity, a finding which undermines the use of these ratios as reliable conditioning variables for the explanation of firms' decisions.

JEL Classification: M41, G12

Suggested Citation

Ioannidis, Christos and Peel, David Alan and Peel, Michael J., The Time Series Properties of Financial Ratios: Lev Revisited. Available at SSRN: https://ssrn.com/abstract=443745

Christos Ioannidis (Contact Author)

University of Bath-Department of Economics ( email )

Claverton Down
Bath, BA2 7AY
United Kingdom

David Alan Peel

Lancaster University - Management School ( email )

Bailrigg
Lancaster, LA1 4YX
United Kingdom
+44 (0)1524 593590 (Phone)
+44 (0)1524 594244 (Fax)

HOME PAGE: http://www.lancs.ac.uk/staff/peeld/

Michael J. Peel

Cardiff University - Cardiff Business School ( email )

Cardiff
United Kingdom

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