Financial ratios serve not only as bellwethers of performance, but as guidelines in formulating corporate objectives. As a result, most studies of ratio behavior exaggerate the ability of managers to adjust their ratios at will. In a recently published study, Wu and his colleague Shih-ren Kathy Ho have used an alternative model to analyze financial ratio behavior. Using data collected from the Compustat tape for the period 1973-1992, Wu and Ho examined six important financial ratios. Moreover, the speed of ratio adjustment differs across firms of different size and industries.
Small firms tend to be more vulnerable to external effects.
However, they are able to restore their desired financial ratio levels faster than larger firms. Overall, Wu and Ho's proposed model provides a more satisfactory frame- work than others do for predicting a firm's future financial ratios and their performance. If poor performance reflects external shocks, then managers cannot be blamed. On the other hand, if failure can be attributed to internal efforts, the company has problems. And these problems cannot even be detected by the prevailing model of ratio analysis.