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A bewildering array of potentially useful financial ratios is available for use. The user, however, will usually want to make decisions based on only a few ratios. For example, Chen and Shimerda 3 identify 41 different ratios that apparently serve some useful predictive or explanatory purpose. This set of 41 ratios is obtained by reviewing 26 previous studies in which a total of 100 ratios are examined. A set of 100 or even 41 financial ratios would be much too cumbersome to be employed in a decision model. Consequently, in several studies 4, 5, 8, 10, 11, 12, 13 an attempt is made to reduce the dimensionality of a variable set by developing patterns among financial ratios via factor analysis. The purpose of this study is to extend previous studies of financial ratio patterns by examining cross-industry stability of financial ratio patterns. A secondary purpose of this paper is to assess the sensitivity of these patterns to differences in accounting constructs, for example, using net income plus depreciation as a proxy for cash flow. The motivation behind developing financial ratio patterns is discussed in the next section.
Gombola et al. (1983) studied this question.