Effect of Growth Rate on Financial Ratios: Theoretical and Empirical Analysis

Abstract

The purpose of the study is to investigate the pure effect of growth on financial ratios (ceteris paribus). This effect is analyzed both theoretically and empirically. Theoretical analysis is consisted of a steady-state model based on growth rate, profitability (IRR), and a lag parameter. Six financial ratios grouped into three categories are examined: cash-flow ratios, profitability ratios, and solvency ratios. The growth effect on these ratios is analytically assessed using partial derivatives and elasticities. Empirical investigation makes use of long-term financial data from Finnish active and bankrupt firms being different in terms of growth, profitability, and lag structures. Theoretical and empirical results demonstrate that profitability ratios are largely insensitive to growth, whereas cash-flow ratios are moderately sensitive, and solvency ratios are highly sensitive. These findings indicate that, when using cash-flow and especially solvency ratios in financial ratio analysis, growth plays an important role.