Lemmings to the Sea: The Inappropriate Use of Financial Ratios in Empirical Analysis

Abstract

Despite the theoretical underpinnings for the use of equity and earnings in economic analysis, certain financial ratios are not suited for econometric models. In particular, when reported shareholder's equity and/or earnings are less than zero, an inverse relationship can exist between financial ratios and actual firm performance. Although certain earnings ratios can be corrected when this happens, corrections to other ratios, in particular those involving negative book values for equity would result in severe sample bias, erroneous results, and misleading conclusions.

Keywords: Return on equity, Financial ratios, Sample bias, Leverage ratios, Use of accounting data in economics

JEL Classification: B41, C81, G29, G30