Study of Behavior on Empirical Investors

Extensive studies were conducted of three categories of investors: individual investors, institutional investors and financial analysts. Both individual and institutional investors regarded long-term capital gains as more important than dividend income which was more important than short-term capital gains. Both individual and institutional investors with portfolios under $10,000 rated short-term capital gains higher than investors with large portfolios [Most and Chang,1979].

All groups in the USA regarded financial statements as the most important source of information for investment decisions. In the United Kingdom, only institutional investors made that judgement. Financial analysts regarded communications with management as the most important source, whereas individual investors preferred newspapers and magazines. Financial statements were found to be equally important for "buy decisions" as for "hold/sell decisions" [Chang and Most,1981].

Study of Behavior on Empirical Investors (2)

A survey of bank lending officers revealed that half of them would refuse to loan to a company that did not submit financial statements, even though these might not be explicitly requested. Bank lending officers exhibited no preference for inventory or depreciation methods, but believed that consistency in the use of accounting methods is important [Stephens,1980].

Another study attempted to compare General Price Level (GPL) and traditional ratios in the prediction of bankruptcy. GPL data was found to be neither more nor less accurate than historical data. To justify the expense of preparing GPL statements, GPL data would have to be more useful. The investigators noted that GPL data may or may not be of value for other uses of accounting data [Norton and Smith,1979].

An extensive study was made of ratio tests in the prediction of bankruptcy. All nonliquid asset ratios performed better than any of the liquid asset ratios -- including the highly-touted current ratio and acid-test ratio -- for anywhere from one to five years in advance of bankruptcy. The researcher explains that a firm with good profit prospects in a poor liquid asset position rarely has trouble obtaining necessary funds. Another surprising discovery was that the failed firms tended to have less rather than more inventory -- contrary to what the literature might suggest [Beaver,1968].

Current Ratio - The Patriarch Ratio

Current ratio (the ratio of current assets to current liabilities) was perhaps the earliest ratio to gain widespread use as a measure of solvency. On the theory that $2 in current assets could safely cover $1 of current liabilities (with enough remaining to operate) a 2-to-1 value became an inflexible standard. But inventories can vary greatly in their liquidities. Oil, for example, can be rapidly liquidated, but inventories of service parts could take years to sell -- hardly "current assets". Also, small businesses can often liquidate their inventories more rapidly than large ones, indicating that current ratio may not be comparable for different size firms. Moreover, the relative investment in inventory rose from 77% of working capital to 83% of working capital between 1950 and 1962 for American corporations [Miller,1966]. Just-In-Time (JIT) inventory control using computers has dramatically decreased the amount of inventory held. Thus, indicators from the past might not be useful for the future. A 1-to-1 "acid-test" ratio which excluded inventory from current assets was a suggested replacement for current ratio, but the liquidity of the receivables portion of current assets is still open to question without information on collectability. In a strike or a recession, the business might have to pay its current liabilities by liquidating its current assets. Yet it is questionable if this could be done without a loss in operating capacity -- especially serious in a recession. In the case of an airline, cash flows are more a function of its current assets than of its non-current assets.