Effect of Expenditure Structure on Profitability Ratios

The aim of the study is to show how the company’s expenditure structure affects the comparability of profitability ratios. The hypothesis is that the impact of the expenditure structure is significant, in which case it weakens the comparability of companies in terms of profitability. In addition to comparability across companies, the potential importance can also be seen in the time series data, where a change in the structure, for example due to investment or earnings management (EM), affects the ratios, although true profitability does not change. In this study, a simple steady mathematical model is developed, in which the profitability ratios are described by means of the internal rate of return (true profitability), growth rate and the lag between expenditure and revenue, as well as the expenditure structure. The importance of the expenditure structure is also investigated with the help of a numerical experiment and empirical data from 832 Finnish companies. The results show that, in accordance with the hypothesis, the expenditure structure has a significant effect on profitability ratios, especially those that are explicitly affected by the expenditure structure. The significant impact of the expenditure structure weakens comparability, and thus more attention should be paid to it when analyzing cross-sectional and time series data.