Modelling the Longitudinal Properties of Financial Ratios of European Firms

The use of financial ratios by analysts to compare the performance of firms from one accounting period to the next is of growing importance with continued European economic integration. Recent studies suggest that the individual component series of financial ratios exhibit nonstationarity which is not eliminated by the ratio transformation. In this paper, w e derive a generalised model that incorporates stochastic and deterministic trends and allows for restricted and unrestricted proportionate growth in the ratio numerator and denominator. When the individual firm series are included in a panel structure with large N and small T, we are unable to reject convincingly a joint hypothesis of nonstationarity, whilst in about one third of the individual firm panels there is no evidence of a unit root. Although the components of financial ratios are correlated variables, our estimates show that any cointegrating effects decay rapidly.