Market Effects, Size Contingency and Financial Ratios

This study presents theoretical and empirical analyses to suggest a previously‐unknown size‐related contingency in the relationship between market variables and various commonly‐used financial ratios, including Net Income/Total Assets, Current Assets/Sales, Current Assets/Current Liabilities, Current Assets/Total Assets, Cash/Total Assets, Long‐Term Debt/Total Assets, Accounts Receivable/Sales. The size contingency in this relationship is shown to be due to the cross‐sectional variability of the ratios themselves. Moreover, simply adding a size dummy to the model will not correct for the problem. Empirical results show that the effect is very strong and subjects to severe misinterpretation any study that uses financial ratios on the right‐hand‐side of a linear model.